In response to extreme pressure on financial markets during the height of the crises, central banks in advanced economies expanded their operations and influence on markets; accepting a wider range of collateral, engaging in large-scale asset purchases and creating special lending schemes.
But the BIS, known as the central bank to the world’s central banks, said in its latest annual report that such tools were most suitable for exceptional circumstances and central banks should now return to influencing short-term policy rates only as a way to affect monetary conditions.
While it acknowledged that it would be tempting for central banks to hold on to their wider range of tools, BIS said there were three reasons to return to a narrower their focus.
Firstly, central banks’ control over long-term bond yields is limited compared with short-term rates. Long-term bond yields are mainly driven by a governments' fiscal policies and balance sheet and affected by its debt management operations.
Secondly, “central bank balance sheet measures can easily blur the distinction between monetary and fiscal policies,” and thirdly, BIS said the expansion in most central banks’ balance sheets in recent years puts their own financial strength at risk.
Higher bond yields, for example, can lead to losses on central banks’ holdings of bonds while changes in exchange rates expose central banks - such as those in Asia or the Swiss National Bank with large foreign exchange holdings - to potential losses.
“All this raises tricky issues concerning coordination with the government and operational autonomy,” BIS said. “For these reasons, such tools are best considered suitable for exceptional circumstances only.”
Since late 2007, central banks’ total assets have roughly doubled to over $20.5 trillion, up from $18 trillion last year, accounting for just over 30 percent of global Gross Domestic Product (GDP), double the ratio of a decade ago.
In the wake of the crises, many central banks in Asia added to their foreign exchange holdings as they resisted upward pressure on their currencies. Following the Asian financial crises in the late 1990s, central banks in that region started accumulating foreign exchange reserves to avoid a repeat.
While the rate of accumulation has slowed in recent years, BIS said foreign reserve holdings in Asian economies amounted to $5 trillion at the end of 2012 – about half of the world’s total stock of foreign reserves, with total central bank assets topping 40 percent of their GDP.
Asian central banks are not the only ones to have boosted their foreign exchange reserves. The Swiss National Bank, which intervened to impose an upper limit on the franc's exchange rate in September 2011, raised its foreign reserves to some $470 billion by the end of 2012, or 85 percent of Swiss GDP.
While narrowing their operational focus, BIS said central banks should expand their overall strategy by integrating financial stability into the conduct of monetary policy.
Prior to the crises, monetary policy frameworks were primarily focused on price stability and independent central bank decision-making.
And while the crises didn’t discredit this focus, BIS said was clear that an environment of low inflation didn’t’ prevent the build-up of financial imbalances that “ushered in the most severe crises since the Great Depression.”
Given the tendency of economies to generate long-lasting booms followed by busts, BIS said this “suggests that there are gains from integrating financial stability considerations more systematically into the conduct of monetary policy.”
While regulatory measures, such as higher capital requirements for banks and regulation of the shadow banking system, will help reduce risks, BIS said some parts of the financial system will be difficult to regulate and macroprudential measures may lose some of their effectiveness over time due to regulatory arbitrage.
Monetary policy will therefore continue to play a key role as “the policy rate represents the universal price of leverage in a given currency that cannot be bypassed so easily," BIS said.
That said, there are “serious analytical challenges” to integrate financial stability into monetary policy as the current macroeconomic models largely ignore the possibility of financial booms and busts.
Work is underway in many central banks to tackle this challenge and Norway’s central bank recently amended its policy model to capture the notion that interest rates that are too low for long can create distortions over time.
BIS was hopeful that these analytical efforts would also lead to a more symmetrical monetary policy.
Over the last 15 years, central banks have responded to every financial crises by slashing policy rates but subsequently only raising them “hesitantly and gradually,” culminating in the current era with rates that are essentially zero.
“A more symmetrical approach would mean tightening more strongly in booms and easing less aggressively, and less persistently, in busts,” BIS said.
Another hope of the BIS is that central banks in the future will better appreciate the “global monetary spillovers in the increasingly globalized world” and put more weight on the global side effects and feedbacks from their policy decisions.
Not only did low interest rates in advanced economies increase global vulnerabilities in the run-up to the financial crises, but they were transmitted and amplified worldwide as emerging markets intervened to counter upward pressure on their currencies and struggled with capital flow pressures.
“The recent build-up of financial imbalances in a number of emerging market and small advanced economies indicates that this mechanism may be at work again,” warned BIS.
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