BIS warns central banks' credibility under threat

     Central banks’ hard-won credibility and independence is threatened by the growing dependence on easy and abundant money by governments and financial markets, the Bank for International Settlements (BIS) said.

    The inability of many governments to tackle major challenges, both short-term deficits and the looming costs of unfunded pensions and healthcare systems, may put central banks under pressure to provide further stimulus, especially if economic growth remains sluggish.

    “However, there is a growing risk of overburdening monetary policy,” BIS said in its annual report. “Any positive effects of easy monetary policy may be shrinking whereas the negative side effects may be growing.”

     Investors and economists are increasingly worried that central banks cannot exit from their extremely accommodative policy in time to avoid inflation.

    But most central bankers, including Federal Reserve Chairman Ben Bernanke, are confident they can tighten policy in time, pointing to inflationary expectations that remain stable, a sign that central banks’ inflation-fighting credentials remain intact.

    “Simply put: central banks are being cornered into prolonging monetary stimulus as governments drag their feet and adjustment is delayed,” BIS said, warning that this “intense pressure puts at risk the central banks’ price stability objective, their credibility and, ultimately, their independence.”

    Near-zero interest rates weaken incentives for the private sector to shore up their balance sheets and for governments to stop borrowing. It also distorts the financial system by triggering a hunt for yield and excessive risk-taking, BIS said.

    Although inflationary expectations currently are stable and close to central banks’ goals, BIS said this should not be seen as a green light for more stimulus.

    “A vicious circle can develop, with a widening gap between what central banks are expected to deliver and what they can actually deliver. This would make the eventual exit from monetary accommodation harder and may ultimately threaten central banks’ credibility,” BIS said, adding:

    “If central banks’ credibility were to be eroded and inflation expectations were to pick up, it would be very difficult and costly to restore price stability, as the experience of the 1970s has shown.”

    Central banks vast holdings of government bonds -- total assets held by central banks have more than doubled over the past four years to around $18 trillion at the end of 2011 – presents a threat to their independence as it starts to blur the lines between monetary and fiscal policy. In the United States, for example, the Federal Reserve purchased 60 percent of all newly issued Treasury bonds last year, in effect subsidizing Washington’s spending.

    “…central banks face the risk that, once the time comes to tighten monetary policy, the sheer size and scale of their unconventional measures will prevent a timely exit from monetary stimulus, thereby jeopardising price stability. The result would be a decisive loss of central bank credibility and possibly even independence.”

    Financial losses on their huge balance sheets could also undermine central banks’ operational autonomy if they have to rely on governments for funding.

    Low interest rates can also mask underlying financial problems, BIS said, looking back at Japan in the 1990s when insolvent borrowers and banks were supported, artificially inflating asset prices that posed a risk to financial stability.

    “An even more important lesson is that underlying structural problems must be corrected during the recovery or we risk creating conditions that will lead rapidly to the next crisis,” BIS said.

    Loose monetary policy in advanced economies since the 2008 global financial crises also presents a threat to emerging economies.

    High interest rates in rapidly-growing emerging economies attracts money and puts upward pressure on exchange rates. But out of fear of boosting capital inflows even further, those central banks hesitate to raise rates. Interest rates may therefore be systematically too loose in emerging markets, helping fuel a boom in credit and asset prices, BIS said.

    “This creates risks of rising financial imbalances similar to those seen in advanced economies in the years immediately preceding the crisis. Their unwinding would have significant negative repercussions, also globally as a result of the increased weight of emerging market economies in the world economy and in investment portfolios,“ said BIS.

    “This points to the need for central banks to take better account of the global spillovers from their domestic monetary policies to ensure lasting financial and price stability.”

    Another effect of loose global monetary policy is to push up commodity prices, and thus inflation, because of their close link to global demand. The growing role of investors in those markets may also have increased the sensitivity of commodity prices to monetary policy, BIS said.

 Click for the BIS 2011/12 annual report

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