Fed Can Limit Spillovers by Avoiding Asset Sales, IMF Paper Says

The Federal Reserve may be able to limit damaging spillovers to emerging economies by refraining from asset sales during its exit from unprecedented monetary stimulus, according to an IMF study.

The side effects for developing nations were much larger when the Fed conducted bond purchases to spur growth in the wake of the global financial crisis than when it relied on conventional changes to its benchmark federal funds rate, International Monetary Fund economists said in a paper published last week.

Fed officials expect to start raising rates at some point next year, normalizing crisis-era policies that have whipsawed emerging-market currencies and capital flows since the U.S. central bank began buying trillions of dollars in bonds in 2008. How officials handle this exit will be vital for emerging economies in 2015, IMF officials have warned.

“To minimize the effects of market surprises, the U.S. Fed and other advanced economy central banks should focus on minimizing shocks to long-term bond yields when they exit from unconventional monetary policies,” authors Jiaqian Chen, Tommaso Mancini-Griffoli and Ratna Sahay wrote in the paper.

“This might be done, for instance, by not selling outright the assets they have accumulated, or at least doing so in a very predictable and mechanical fashion,” they said.

The Fed cut rates almost to zero in December 2008 after the financial crisis tipped the U.S. economy into recession. To reinforce this measure, the Fed also began a series of bond-purchase campaigns to hold down long-term borrowing costs, ballooning its balance sheet five-fold to $4.5 trillion.

The asset purchases ended in October and officials this month replaced a pledge to hold borrowing costs low for a “considerable time” with an assurance that they would be patient in the timing of rate increases.

Exit Strategy

The Fed has also outlined an exit strategy to gradually slim its balance sheet, primarily by ceasing to reinvest principal repayments of the assets it now holds. That process will start after the Fed begins to raise rates, and it doesn’t plan to sell the mortgage-backed securities it has bought.

The IMF study suggested spillovers may have been bigger when the Fed was buying bonds because such measures marked a major policy turning point. It also found spillovers were larger during the so-called taper tantrum of May 2013, when then-Fed Chairman Ben S. Bernanke surprised markets by appearing to signal an imminent reduction in the pace of bond purchases.

The paper is the first to compare emerging-economy spillovers during periods of conventional and unconventional monetary policy, the authors wrote.

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