Monetary Exit Strategy: Building a Better Endgame

Introduction

In the world of monetary policy, one crisis can beget another. Much political and economic attention is tuned to the art and science of using interest rates to mop up messes in a post-bubble world. Far less attention is paid to exit strategies from these policies. However, the consequences of these central banking decisions are no less important.

In theory, an interest rate regime should follow a simple Keynesian narrative as an economy traverses the business cycle. When crisis hits, the central bank is tasked with lowering the interest rate to promote lending and investment. Once conditions improve, the traditional monetary authority re-raises rates, tightening credit conditions and leaning against an inflating economy. These high rates are sustained until crisis returns, at which point the looser recessionary policy takes hold once again.

This narrative, however, is too simple to accurately describe the nuanced history of monetary policy in the developed world. This paper considers two historical case studies: Japan in the mid-1990s and the United States in the mid-2000s.

Japan and the “Lost Decade”

The seeds of Japan’s “lost decade” were sown in the 1980s. Strong GDP growth and low interest rates stimulated substantial investment, turning economic optimism into bullish euphoria. As the output gap fell below zero, investors began pouring yen into the stock and real estate markets.[1] The Nikkei 225 shot up over 400% between 1986 and 1989,[2] while a nationwide urban land price index grew 50% before peaking in 1990.[3] These asset markets quickly overheated, raising concerns about a bubble economy. In response, the BOJ raised the overnight call money rate in an effort to lean against the bubbles, but it was too little too late.

The bursting of the bubble brought an end to an era of prosperity in Japan. The Nikkei lost nearly 50% of its value between 1989 and 1991. GDP growth, which had peaked at 7% in 1990 and fallen to 2.5% by the end of 1991, continued its decline, hitting zero growth by the middle of 1992. Inflation, which had peaked at 4% in 1990, dropped steadily, hitting zero in 1994 and bringing destructive bouts of deflation after 1995.[4]

Economists disagree over the source of Japan’s prolonged slump. Hayashi and Prescott (2002) call upon the neoclassical growth model and show that the decade of near-zero growth can be accounted for entirely by low total factor productivity growth and by a reduction in the average workweek.[5] Krugman (1998), meanwhile, argues that the stagnation results from a liquidity trap—a zero interest rate policy left the monetary authority with insufficient tools to revive the economy.[6] Koo (2009) disagrees with Krugman, arguing that Japan suffered a “balance sheet recession”: in essence, the collapse in asset prices turned firms’ focus away from profit maximization and instead toward debt minimization. Firms were so busy cleaning their balance sheets that they were not interested in taking out new loans. As a result, the BOJ’s interest rate regime failed to gain traction.[7] Bayoumi (2000) points to the banks, suggesting that undercapitalization and falling asset prices led banks to curtail lending in an effort to maintain capital adequacy standards. This credit crunch, the author holds, had huge consequences on the real economy.[8] Throughout this episode, the BOJ was hard at work pumping liquidity into the economy in an effort to alleviate economic stress.

BOJ monetary policy took a number of interesting turns during the lost decade. At the end of the 1980s, the central bank began tightening in an effort to lean against the ballooning asset bubble. The overnight call money rate jumped from 3% in 1988 to 6% by 1989. Despite the crash of the stock market in early 1990, land prices continued to rise. As a result, the monetary authority continued to raise interest rates until August of 1990, months after GDP started to contract sharply. Soon, however, policy caught up with the slowdown. The BOJ’s interest rate dropped from its peak of 8.2% in March 1991 to just 2% in March 1995. The rate dropped even further to .5% by October 1995, just as the economy was beginning to hit its stride once more. However, with the onset of Asian financial crisis in 1997, the interest rate hit its lower bound and the BOJ found itself out of bullets.[9]

This interest rate regime from 1990-1996 holds up well against a Taylor Rule estimation of the optimal policy rate. Ahearne et al. (2002) compare the BOJ’s realized call money rate to two different Taylor Rule paths: one using forecast data available in the 1990s and one using actual realized output and inflation figures. In Figure 6, the authors show that from 1990 to 1995, the BOJ’s call money rate was remarkably similar to the Taylor Rule using forecast data but consistently above the Taylor Rule recommendations using realized data.[10] Bernanke and Gertler (1999) agree with Ahearne. Constructing a Taylor Rule using realized economic data, they find (Figure 7) that the years 1992-1996 suffered from excessively high interest rates, suggesting that the optimal rate from 1993-1995 would actually have been negative.[11]

In order to draw exit strategy lessons from the unique experience of the BOJ, one must examine the impact of the monetary regime from 1990-1996. Overall, simple time series correlations suggest that the continued slashing of interest rates had a positive effect on GDP growth. Rates were slashed at the end of 1990 and real GDP growth began modest recovery in early 1992. Rates continued to fall as GDP rose slowly from 1992-1995. In 1995, the BOJ cut rates almost instantly from 2.5% to .5%, reflected in a GDP growth jump from 2% in 1992 to 4% in 1995. Bayoumi (2000) would disagree with this correlational evidence, pointing to a credit crunch as evidence that banks were unwilling to extend loans despite the low rates.[12] Koo (2009) would disagree on different grounds, asserting that the balance sheet crisis led firms to avoid borrowing despite low rates.[13]

As both Ahearne et al. (2002) and Bernanke and Gertler (1999) point out, unexpected adverse shocks to output and inflation led to an overly tight policy rate when held up against realized economic data.        This deflation crippled the Japanese economy. First, deflation led to a transfer of wealth from debtors to creditors, then it stimulated an increase in unemployment, as wage rigidities prevented the labor market from accurately responding to the change in the nominal wage rate.

Finally, the post-crisis monetary regime brought Japan into a prolonged liquidity trap. As nominal interest rates approached zero in 1995, the BOJ ran out of room to lower rates. This led to sub-optimal interest rates from 1995-1997. Ahearne et al. (2002) and Bernanke and Gertler (1999) agree that the Taylor Rule recommendation for the optimal rate dipped below zero during this period (see Figures 6 and 7). However, because the nominal interest rate is bound above zero, these optimal rates could not be achieved using the conventional toolkit. Thus, policy was too tight from 1995-1997, leading to slow GDP growth and deflation.[14]

Central banks facing liquidity traps do possess a host of alternative means by which to stimulate the economy. For example, in the early 2000s, in an effort to reduce long-term interest rates, the BOJ targeted expectations of future short-term rates by making a commitment to continue their zero interest rate policy for an extended period of time.[15] Alternatively, as demonstrated first by Japan in the late 1990s and then by the US in the late 2000s, central banks can promise to purchase long-term securities at a price consistent with low long-term interest rates. However, Japan did not take any of these unconventional steps when the economy first experienced a liquidity trap in 1995.

The US Between Recessions

The US case begins with the “dot-com” bubble that fueled GDP growth and speculative asset price increases from 1995-2000. From January 1998 to January 2000, the Dow Jones Industrial Average ballooned from 7,700 to 11,700 points, driven by extreme growth in the technology sector.[16] As the bubble inflated, Fed Chairman Alan Greenspan raised the federal funds rate six times between 1999 and 2000 in an effort to lean against the bubble. The economy gradually slowed until the bubble finally burst in early 2000, and the shock of this was compounded by both a series of corporate scandals and the 9/11 terrorist attacks.

What began as a slowdown snowballed into a recession. The Dow slipped from its peak of 11,700, falling below 10,000 in February of 2000 and continuing downward until bottoming out at 7,500 in October of 2000.[17] GDP growth would also tumble, falling from a peak of 5% in 1999 to 1% in 2001. However, recovery followed quickly. Aggressive fiscal and policy measures, in the form of tax cuts and interest rate cuts, stabilized the economy. GDP growth bounced back up to 3.5% in 2004 and remained above 2% until 2007. Prices remained stable, falling from 3.5% inflation in 2000 to 1% inflation in 2003 and rising back up to 4% by late 2006. Asset prices, however, rose precipitously.[18] The Dow Jones exploded from its low of 7,500 in October of 2000 to a high of over 14,000 in 2007—nearly doubling in value. Even more troubling was the growth in housing prices (as reported by the Case-Shiller Home Price Index). These had remained relatively stable from 1990-1996 before embarking on a remarkable upward trend. From 1998-2000, annual growth had increased from 10% to 15% before falling back to 10% in 2001. With recovery came a wild increase in house prices, as annual growth rose from 10% in 2001 to an astounding 20% in 2004.[19]

In 2007, this blazing growth came to a rapid halt. The slowdown began with a decline in housing prices, as annual growth fell from 20% in 2004 to 15% in 2006 and then all the way to -20% by 2009. The stock market experienced a similar slide, with the Dow dropping from its 14,000 peak in 2007 to 12,000 in early 2008 and then freefalling all the way to 6,500 in early 2009.[20]

The years from 2002-2006 provide a perfect case study for monetary policy and exit strategies to hold up against the more unconventional experience of Japan during the lost decade. Greenspan raised the federal funds rate six times between 1999 and 2000 in order to lean against the growing dot-com bubble, leaving the rate at 6.5% through the start of 2001. With the onset of the recession, the Fed immediately began to loosen its policy. The federal funds rate tumbled to 1.75% by 2002 before dropping to 1.25% in 2003 and then 1% in 2004. As the economy recovered through 2004, the interest rate remained at the extreme 1% mark. Not until 2005 did the Fed exit from its post-crisis regime, tightening gradually until the federal funds rate reached 5.25% in late 2006, where it remained until the onset of the financial crisis in 2007.[21]

Unlike the BOJ’s policy, the Fed’s interest rate regime performs poorly when compared to a Taylor Rule estimation of the optimal policy. An estimate from Taylor (2007) shows that Greenspan waited far too long to exit from its post-crisis monetary regime, sustaining extremely low rates when output and inflation figures called instead for relative tightening. Figure 14 shows that the Fed should have begun re-raising interest rates as early as 2002, gradually increasing to 5% by early 2005. In comparison, the monetary authority actually decreased rates from 2002 to 2004, leaving them a full 3% below the Taylor Rule recommendation. Not until 2006 did the federal funds rate come back in line with the Taylor Rule’s recommendation.[22] Monetary was also far too loose to be optimal. Greenspan kept the federal funds rate at recessionary levels even as the economy appeared to make a full recovery. In fact, rates remained low even as asset prices began to balloon in 2005.

Correlational data suggests that this loose monetary policy, together with substantial tax cuts, fueled speedy recovery following the dot-com crisis. As the federal funds rate sat below 2% between 2002 and 2005, GDP growth took off, rising from 1.5% in 2002 to 3.5% by 2004.

Many, have accused the Fed’s loose interest rate regime with inflating the housing bubble and thus facilitating the global financial meltdown in 2007. Greenspan’s exit from the recessionary policies begun in 2001 was too late and too slow. As a result, low interest rates persisted in a healthy economy and generated an overflow of liquidity. Among those criticizing the Fed is Taylor (2008), who claims that the Fed’s deviation from 20 years of more prudent monetary policy directly accelerated the housing bubble. To prove this, he estimates housing starts through a counterfactual model in which the Fed’s interest rate follows the Taylor Rule prescription, and compares these results to realized housing starts. As shown in Figure 16, strict Taylor Rule monetary policy would have allowed the US to avoid the crisis almost completely.[23]

The reluctance to tighten monetary policy at the speed implied by the Taylor Rule suggests that Greenspan may have hesitated under political pressure. As Greenspan himself describes, “During my eighteen-and-a-half-year tenure, I cannot remember many calls from presidents or Capitol Hill for the Fed to raise interest rates. In fact, I believe there was none…”

Lessons from History

The first and most obvious lesson drawn from this picture is that exit strategies can have incredibly important consequences. In the Japanese case, the liquidity trap and deflation that resulted from post-crisis monetary policy represent serious economic challenges that still haunt Japan’s economy. In the US case, the housing market crash fed by loose interest rates brought the nation’s most powerful recession since the Great Depression. While this economic turmoil would likely have persisted even without the contributions of central banks, monetary policy exit strategies certainly fanned the flames of catastrophe.

The second lesson of the case studies is that interest rate risks are a two-sided phenomenon. In the case of Japan, monetary policy was too tight considering realized data, and this brought about crippling and persistent deflation. In the case of the Fed, policy was too loose, feeding asset price inflation and bubble behavior. Thus, there is no simple prescription for evaluating interest rate risk asymmetrically; price level danger lurks both above and below.

This leads to a third lesson—that optimal monetary exit strategy is ultimately a path-dependent problem. The Japanese and US cases demonstrate that the risks associated with monetary exits—whether inflationary or deflationary—depend on the conditions leading up to the exit. When assessing risks, policymakers clearly must weigh the severity of the initial bubble (Japan’s bubble was bigger, sparking deflation), the structural resilience of the economy (Japan faced structural issues, also feeding deflation), general price stability (the US enjoys greater price stability and thus avoided deflation), current trends in asset prices (the US housing market was already inflated, triggering the negative impacts of the loose monetary policy) and the feedback between asset prices and real economic variables (the US has deep ties between these, enhancing the effects of the housing bubble crash). Further, the Japanese case demonstrates that adverse economic shocks can throw another wrench into the problem (price and GDP shocks led Japanese policy to be too tight in hindsight).

Fourth, there are clear dangers associated with both rule-based and decision-based monetary policy in a post-crisis economy. The Japanese case demonstrates that rule-based policy is vulnerable to adverse shocks. BOJ policy that appeared to be optimal according to a strict Taylor Rule prescription turned out to be too tight due to shocks to GDP and inflation. On the flip side, the US case demonstrates that true “classic” banking, ignoring the Taylor Rule recommendations, is prone to the dangers of politicization. Greenspan’s revealing statements indicate that a holistic approach to banking can leave rates subject to political pressure to maintain loose policy. The result was a delayed exit that fed a dangerous asset bubble. Thus, there is no single dominant strategy.

Finally, there are special economic risks associated with a zero interest rate policy. Among other things, entering into a liquidity trap leaves a central bank with no interest rate weapons to combat further economic shock.

In short, all of these consequences are two-sided—both tight and loose monetary policy come with large risks—and the balance between these risks is path-dependent.

Policy Recommendations

This paper recommends a rule-based exit strategy. This framework would not represent a specific pre-commitment to maintenance of a single variable, as in an inflation-targeting scheme. However, it would represent a pre-commitment to a set of policy rules. Specifically, the central bank would be required to lay out and communicate a multi-year baseline forecast for the economy (under recovery), using advanced models to predict levels of output growth, unemployment, inflation and asset prices. The bank would then lay out and communicate an optimal interest rate policy path consistent with the forecast. This rules-base system would be holistic, incorporating all relevant economic data into a model-based optimization.

The fate of the economy should not be left to the whims of an individual, and a rule-based system naturally induces objectivity. Equally important, this rule-based system would remove the temptation of politicization. The US case above highlighted the risks of leaving policy open to political influence, as the short election cycle rewards overly-loose monetary policy that has potential to inflate asset bubbles.

This strategy would also allow for increased transparency. Published forecasts and planned policy paths would keep the public in tune with the central bank’s activities. This, in turn, would increase the credibility of the bank. Deviations from the optimal policy path would result from forecast misses due to economic shocks and would thus be easy to communicate to the public. This would reduce the credibility cost of surprising policy. Heightened transparency represents a non-trivial benefit, particularly in the midst of monetary exit, when confidence in the central bank will likely be low.

One of the most important advantages of a rule-based system lies in its impact on expectations. By publishing target rates and projections, the central bank would provide an explicit “reference point” for expectations of future interest rates (as well as other economic variables).[24] These expectations are important for catalyzing economic changes through monetary policy. Gurkaynak, Sack and Swanson (2004) confirm this by demonstrating that three-fourths of the explainable variation in the movements of five- and ten-year Treasury yields around FOMC meetings is accounted for by the statements released by the FOMC, rather than by changes in the actual federal funds rate.[25] Rudebusch and Williams (2008) use a theoretical analysis to show that central bank communication of interest rate projections better aligns the public’s and central bank’s expectation. This alignment, they demonstrate, leads to improved macroeconomic outcomes.[26]

Of course, there are considerable costs associated with a rule-based framework. Among these is the increased cost of a forecast “miss.” As Rudebusch and Williams point out, the heightened sensitivity of future interest rate expectations can increase the costs of economic shocks. In their paper, they emphasize the need for a communications strategy that highlights the conditionality and uncertainty surrounding the central bank projections.

The second central feature of this exit strategy recommendation attempts to mitigate the costs of these deviations. As suggested by Ahearne et al. (2010) in reference to deflation, this policy rule should be weighted asymmetrically to guard against various economic risks, thus insuring that a forecast miss does not result in catastrophe. In the case of Japan during the lost decade, this would have meant over-weighing the risk of deflation and thus generating a looser policy rule. In the case of the US after the dot-com bubble, this would have meant over-weighing the risk of an asset bubble and thus generating a tighter policy rule.

The challenge, of course, is knowing how to weigh various economic risks. This is where the path-dependency of optimal exit strategies can be beneficial. The Japanese and US cases demonstrate that the economic circumstances leading up to a monetary exit provide substantial clues as to the special risks faced and thus the optimal interest rate regime. The size of a bubble and subsequent recession can influence in the relative risks of inflation versus deflation. A bigger bubble, as in the case of Japan in 1990, can induce deflationary risks post-recovery. A smaller bubble, as in the case of the US in 2000, can result in over-correction and asset price inflation during policy exit. Finally, central banks should carefully consider the path of asset prices in calculating the risk of loose policy inflating an asset bubble. This is no simple task, but considering the enormous costs of the housing bubble burst, it is a crucial one. As Greenspan quipped, “There is little dispute that the prices of stocks, bonds, homes, real estate, and exchange rates affect GDP. But most central banks have chosen, at least to date, not to view asset prices as targets of policy… asset prices will remain high on the research agenda of central banks for years to come.”[27]

The third feature of this recommended framework concerns exit from unconventional monetary regimes. In times of deep, prolonged crisis, some central bankers find that driving the short-term interest rate to the zero nominal bound falls short of stimulating desired levels of investment. Both Japan in the mid-2000s and the US today have experimented with quantity controls, purchasing longer-term securities at prices consistent with lower long-term interest rates. While this technique was not employed by Japan during the lost decade or the US after the dot-com bubble, it represents a popular new solution to the liquidity trap.

This policy recommendation calls for a particularly slow, careful exit from quantity controls. Should a central bank find its balance sheet immersed in long-term securities, the banker should exercise patience in unloading those commitments. The monetary authority should factor the effect of these purchases into the policy forecast, but begin monetary exit by starting to unwind interest rate controls before unloading balance sheet controls.

The primary motivation for this conservative strategy is uncertainty. There is little precedent to help predict the effects of a massive security sell-off on the economy, financial markets and the prices of the securities themselves. Under such uncertainty, a slower sell-off plays a crucial role in avoiding unanticipated complications. In 2010, the FOMC arrived at the same conclusion, noting that “Most participants favored deferring asset sales for some time. A majority preferred beginning asset sales some time after the first increase in the Federal Open Market Committee’s (FOMC) target for short-term interest rates.”[28]

Some have expressed concern that a slow exit from recessionary quantity controls could trigger increases in inflation expectations and thus inflation. However, Rudebusch (2010) refutes these claims, showing in Figure 17 that the massive increase in Fed liabilities from less than one trillion dollars in October of 2008 to over two trillion dollars in December of 2008 had no discernable impact on long-run inflation expectations, as measured by the Survey of Professional Forecasters.[29]

Conclusions

To summarize, this paper recommends a three-pronged policy framework for monetary exit regimes. The first feature is a rule-based strategy in which the central bank is required to lay out an economic forecast and an estimate of the optimal interest rate policy path. This would remove subjectivity in rate-setting, reduce the temptations of politicization, inspire more confidence and accountability in the central bank and strengthen the link between monetary policy and expectations. To minimize the considerable costs associated with forecast “misses” under a rule-based regime, the second tenet would have the bank asymmetrically weigh the costs of various economic risks. Specifically, central bankers should use the history of path-dependence in optimal exit strategies to determine which risks realistically merit active prevention. These asymmetric risks should include the threat of asset price inflation. Finally, this policy recommends a slow unwinding from quantity controls. Because of the uncertainty, imprecision and sheer magnitude associated with the purchase and sale of long-term securities, central banks should unwind with extreme caution only after beginning price control exit.

These lessons are highly relevant to the current policy debate in the US. Bernanke’s extreme interest rate and balance sheet policies have left the Fed in need of a well-designed exit strategy. As the Japanese and US cases have shown, even small failures during the endgame can produce disastrous consequences down the road. While Bernanke holds that it is too early to begin unwinding, the Fed must use history as its guide in a post-crisis policy world. Will Bernanke learn from the lessons of Japan to avoid a protracted deflationary slump? Will he draw on his predecessor’s errors to prevent rampant asset price inflation? The answers to these questions will shape the path of the global economy for years to come.

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