May 16, 2013 / 3:44 PM / in 4 years

Bank of Canada sees unorthodox-policy benefits outweighing risks

OTTAWA (Reuters) - The risks of unconventional policies pursued by major central banks since the financial crisis appear to be minor compared with the benefits, Bank of Canada researchers said on Thursday.

As policymakers at the U.S. Federal Reserve ponder how to withdraw some of the extraordinary stimulus they’ve been pumping into the economy, there are worries that moving too quickly could undermine economic recovery but moving too slowly could fuel inflationary pressures or create new asset price bubbles.

“While central banks must be mindful of the potential costs and risks of their actions, currently these issues do not appear to present sufficient cause to restrict the use of these measures,” Bank of Canada economists Eric Santor and Lena Suchanek wrote in a paper published in the quarterly Bank of Canada Review.

Much of the debate on the Fed’s exit strategy has focused on what types of asset purchases should be scaled back. The Fed’s balance sheet has more than doubled since 2007, exposing it to potential losses because of the types of assets it has purchased.

Most economists do not expect the Fed to reduce its $85 billion in monthly bond buys as soon as June’s policy meeting, given still high U.S. unemployment and weak inflation.

But Dallas Fed President Richard Fisher said on Thursday the U.S. central bank should reel in its purchases of mortgage-backed securities [ID:nN9N0CX02Q] and Philadelphia Fed President Charles Plosser said it should start reducing assets next month. [ID:nL6N0DX2DA]

The International Monetary Fund warned on Thursday that the unprecedented central bank actions risk heavy losses for central banks when the time comes to exit.

The Bank of Canada’s Santor and Suchanek note there is overwhelming evidence of the usefulness of the suite of actions - ranging from liquidity facilities to massive bond purchases known as quantitative easing - central banks have taken.

There is less hard analysis of the potential costs, they said.

These include the possible undermining of central bank credibility, facilitating large fiscal deficits or asset price bubbles, exposing central banks to losses on their assets and encouraging excessive risk-taking by institutional investors.

Even less clear is what effect unwinding these unprecedented strategies will have.

Using the Fed as an example, the authors note that central banks can absorb any future losses on their balance sheets without impairing their ability to raise interest rates. The losses would be “minor” compared with the greater benefit of economic growth, they argue.

“While unconventional policies appear to have achieved their objectives to date, it is too early to judge the overall success of such practices, since it remains unclear how well central banks will exit from these policies.”

Reporting by Louise Egan; Editing by Peter Galloway

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