BIS Says Central Banks Need to Start Increasing Rates to Contain Inflation

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By Christian Vits - Jun 26, 2011 8:30 AM PT

The Bank for International Settlements in Basel, Switzerland. Photographer: Christophe Bosset/Bloomberg
Central banks need to start raising interest rates to contain inflation and may have to act faster than in the past, the Bank for International Settlements said.
“Tighter global monetary policy is needed in order to contain inflation pressures and ward off financial stability risks,” the BIS said in its annual report published today in Basel, Switzerland. “Central banks may have to be prepared to raise policy rates at a faster pace than in previous tightening episodes.”
While policy makers in Asia and Latin America are already raising borrowing costs to damp price pressures, rates remain near record lows in the world’s largest developed economies. Central banks in the U.S., U.K. and Japan have signaled they intend to keep that stimulus in place for some time, with only the European Central Bank moving to gradually tighten credit as inflation risks increase.
“Global inflation pressures are rising rapidly as commodity prices soar and as the global recovery runs into capacity constraints,” said the BIS, which acts as a central bank for the world’s central banks. “These increased upside risks to inflation call for higher policy rates.”
Crude oil prices have gained 20 percent in the last 12 months, putting pressure on companies to pass on higher costs.
Negative Real Rates
BIS General Manager Jaime Caruana said global headline inflation has risen a percentage point to 3.6 percent since April 2010, while “real short-term interest rates have actually fallen in the past year, from minus 0.6 percent to minus 1.3 percent globally.”
“The world economy is growing at a historically respectable rate of around 4 percent,” Caruana said in a speech in Basel today. “The resurgence of demand has put concerns about deflation behind us. Accordingly, the need for continued extraordinary monetary accommodation has faded.”
The ECB in April raised its benchmark interest rate from a record low of 1 percent and has signaled another quarter-point step is likely in July.
By contrast, the Federal Reserve last week repeated a pledge to keep its policy rate close to zero for an “extended period,” and minutes from the Bank of England’s last policy meeting, at which the bank held its key rate at 0.5 percent, showed some officials see the potential for more monetary stimulus through further bond purchases. The Bank of Japan this month held its benchmark near zero and kept credit and asset- purchase programs in place.
Risk of Distortions
The BIS said that in “some advanced economies” policy tightening still needs to be balanced against the “vulnerabilities” associated with private and public sector balance-sheet adjustment and financial-sector fragility.
At the same time, “undue delay in the normalization of the monetary policy stance entails the risk of creating serious financial market distortions, the postponement of deleveraging and the misallocation of resources,” it said. Furthermore, a “timely tightening” of policy in both emerging-market and advanced economies will be needed “to preserve a low-inflation environment globally and reinforce central banks’ inflation- fighting credibility.”
The BIS said central banks should also reduce the size of their balance sheets, though it would be “dangerous” to cut them “too rapidly or too indiscriminately.”
Balance Sheets
In response to the financial crisis, the Fed and the Bank of England “sharply” increased their total assets from about 8 percent of gross domestic product to just below 20 percent, according to the BIS. The ECB expanded its assets from 13 percent of GDP to more than 20 percent. In emerging markets, central bank balance sheets “grew more gradually over the past decade,” the BIS said.
“Balance sheet policies have supported the global economy through a very difficult crisis,” it said. “However, the balance sheets are now exposed to greater risks -- namely interest-rate risk, exchange-rate risk and credit risk -- that could lead to financial losses.”
The BIS urged governments to pursue fiscal consolidation, saying the biggest risk is “doing too little too late rather than doing too much too soon.” In Europe, policy makers must fix the region’s debt crisis “once and for all,” it said.
‘No Shortcut’
“Nowhere is the link between fiscal sustainability and financial health more apparent than in parts of Europe today,” Caruana said. “There is no easy way out, no shortcut, no painless solution.”
The BIS also warned that a failure of the U.S. to tackle its budget deficit could become a source of instability, with potentially “far-reaching ramifications for the global economy” should a rapid depreciation of the dollar result.
“The current ability of the United States to easily finance its deficit cannot be taken for granted,” the report said.
The BIS holds currency reserves on behalf of its members and provides policy makers with a forum for discussion. Attendees at the annual general meeting in Basel today include ECB President Jean-Claude Trichet, Fed Chairman Ben S. Bernanke, Bank of Japan Governor Masaaki Shirakawa and Bundesbank President Jens Weidmann.
To contact the reporter on this story: Christian Vits in Basel at cvits@bloomberg.net
To contact the editor responsible for this story: Matthew Brockett at mbrockett1@bloomberg.net