Raising interest rates to get the economy back onto a normal setting could prove so complicated it “undermines the recovery”, the International Monetary Fund has warned.
Central banks, including the Bank of England, strayed into “unchartered waters” by cutting interest rates to near-zero and launching billions of pounds of quantitative easing, and they will find the exit “difficult to control”, the IMF said. “The market response [to a rise in interest rates] will be less predictable ... possibly for several months or even years.”
Long-term interest rates could spike as investors dump over-priced bonds and banks could face a fresh round of losses on both their gilt portfolios and loan books as borrowers struggle to meet higher monthly payments, it added.
“This risk makes it very important that any necessary bank restructuring and recapitalisation is completed as soon as possible,” IMF financial stability deputy chief Erik Oppers said. “Credit risk for banks may increase. Higher interest rates make it harder for bank customers to pay back their loans.”
The IMF’s analysis followed a warning earlier this week from two former members of the Bank's Monetary Policy Committee that rate rises would result in an economic "shock" to the UK. Early signs of growth have raised the prospect of an earlier return to normal interst rate policy than the markets currently believe.
Sir Mervyn King, the Bank's Governor, said this week that "it may be possible to raise rates faster than current market expectations" of no increase until late 2016.
The IMF also confirmed earlier work by the Bank that warned of large losses on central bank balance sheets. In a shock scenario, under which rates would need to rise by six percentage points, losses on the current £375bn QE programme in the UK could reach 4.5pc of GDP – or £70bn. Even under a “likely case” scenario where rates rose by four percentage points, the loss would be £50bn.
The Bank has previously calculated that the interest income on the £375bn of QE would more than offset the exit losses in all but the most extreme case, when the taxpayer could end up £8bn out of pocket. The IMF analysis excluded “the income from asset holdings”.
A Bank official said: "As the IMF report acknowledges, this analysis ignores capital gains and coupon income from bondholdings. That makes the results very misleading."
For the economy more broadly, though, the IMF said the risks were considerable. “The risk is interest rate volatility and overshooting in the adjustment of long-term rates. The potential sharp rise in long-term interest rates could prove difficult to control, and might undermine the recovery (including through effects on financial stability and investment),” it wrote in a policy paper.
It also argued that there was clear evidence of “diminishing returns” in continuing with existing policies like QE. The most effective policy now, it suggested, was “conditional guidance” of the sort used by the US Federal Reserve and under review by the Bank. It has also been championed by incoming Governor Mark Carney.
The IMF paper said guidance was “preferable” to “price-level or nominal-GDP targeting”.
“A possibly more promising approach may be to explicitly characterize the conditions or 'thresholds’ leading to an interest rate lift-off. While avoiding the pitfalls of the above rules, guidance based on thresholds continues to offer an automatic stabilizer, in the sense that as the economy weakens, expectations will automatically shift to a later lift-off date,” it said.
However, it said room for manoeuver was “limited” because the central bank would have to be “willing to accept an inflation rate much higher than its objective”. In the UK, inflation is not expected to return to 2pc until 2015.
Mr Carney is under pressure in the UK to launch more monetary stimulus but the IMF warned that there were risks unless the economy was clearly in need of help. “In a scenario where the economy grows moderately, the net benefits of pursuing unconventional monetary policies are more ambiguous, and weighing benefits against potential costs will be more challenging,” it said.
The IMF suggested that “guidance” may be more useful as part of the move back to normal policy than to try to accelerate slow growth. “Clear forward guidance would help manage expectations of future short rates... And when central banks resort to asset sales, these could be pre-announced to dampen movements in term premia,” it said.