Central banks face tough exit decisions - BIS's Caruana

    Major central banks will decide how and when to exit from extraordinary easy monetary policy with much less certainty that they probably will like but they cannot afford to wait for irrefutable evidence, said Jaime Caruana, general manager of the Bank for International Settlements (BIS).

    Speaking to the annual meeting of Basel-based BIS, Caruana said nobody really knows “how central banks will exit, or what they will exit into.”

    BIS, known as the central bankers' bank, is owned by 60 central banks and monetary authorities, including the U.S. Federal Reserve and the Bank of Japan. About 80 central bank governors and deputies listened to Caruana's speech. 

    After five years of very low interest rates and massive asset purchases, major central banks will need to draw on all their communication skills to make the exit from such policy as smooth as possible.

   The expanded range of tools that central banks have crafted and used since the global financial crises – such as forward policy guidance, lending schemes, bond purchases – give central banks more flexibility and they will certainty need to use that, Caruana said.

    "And they will have to take decisions with much less certainty than they would probably like - waiting for irrefutable evidence may complicate exit and prove costly," Caruana said. "The bigger the scale and scope of their interventions, the more difficult it will be to reduce them."

    Since the beginning of the global financial crises almost six years ago, central bank balance sheets have doubled from $10 trillion to more than $20 trillion while governments have continued to pile up debt, which has risen by $23 trillion since 2007, Caruana said.

    Without such a forceful response, the global financial system could have collapsed, bringing the world economy down with it. But the recovery has been halting, fragile and uneven. Further rounds of policy easing has only lead to continued growth in private credit, weaker lending standards, record equity prices and record low long-term yields.
    But easy financial conditions can not revitalize growth when balance sheets are impaired and resources misallocated on a large scale, he said.
    "It does not matter how attractive the authorities make it to lend and borrow - households and firms focused on balance sheet repair will not add to their debt, nor should they," he said.
    Prolonging the period of very low interest rates only magnifies the challenges of normalising monetary policy, raises the risk of financial stability and worsens the misallocation of capital. It also further exposes open economies, such as emerging markets, to spillovers with strong capital inflows exacerbating such risks.
    "And they expose economies to large sudden reversals if markets expect an exit from unconventional policies, as volatility during the past few weeks seems to indicate," Caruana said.
    "In short, the balance of costs and benefits entailed by continued monetary easing has been deteriorating," with further stimulus just taking the pressure off those who need to act and encouraging the build-up of even more debt, he said.
   Despite some deleveraging by households, total debt - public and private - has risen by about 20 percentage points of Gross Domestic Product in major advanced and emerging economies, or by $33 trillion, with government debt the main driver.
    "Government attempts at fiscal consolidation need to be more ambitious," especially for those that currently enjoy low funding costs, such as the United States and the United Kingdom.
    At the same time, governments in advanced economies need to speed up reforms to allow labour to be employed where it is most productive as a way to counter the decline in labour productivity growth that has been observed since the 1980s.
    Low interest rates have only reduced the urgency to reform but Caruana appealed for shared responsibility to strengthen growth and avoid even costlier adjustments down the road.
    "Monetary policy has done its part. Recovery now calls for a different policy mix - with more emphasis on strengthening economic flexibility and dynamism in stabilising public finances," he said.
    Caruana's five-year term as BIS general manager, which was due to expire end-March 2014, was extended by the BIS board of directors, to March 2017 when he will retire at age 65.

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