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

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.”

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.

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