BIS = boost interest rates soon

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This post is a guest contribution by  Joachim Fels of Morgan Stanley.

BIS stands for ‘Boost Interest Rates Soon’: We’ve argued for some time that risks to global inflation are on the upside over the medium term, reflecting the very easy global monetary policy stance and the strong possibility that traditional measures of slack in the economy are significantly overestimated. The Bank of International Settlements (BIS) strongly agrees, as its 81st Annual Report, published earlier this week, makes abundantly clear. The central banks’ bank bluntly concludes that “[t]ighter global monetary policy is needed in order to contain inflation pressures and ward off financial stability risks” and warns that “[c]entral banks may have to be prepared to raise policy rates at a faster pace than in previous tightening episodes”.

But the Fed and BoE disagree: Needless to say, the BIS view sharply contrasts with the Fed’s current assessment that inflation pressures in the US are likely to be transitory and interest rates can thus remain low for an extended period of time, as reiterated by Chairman Bernanke in last week’s press conference. It also contrasts with the Bank of England’s stance, of which the BIS says “one wonders how long its current policy can be sustained”. Indeed, Adam Posen, a dovish member of the Bank of England’s MPC, was quick to respond by labelling the BIS analysis “nonsense”. So let’s take a closer look at the alleged “nonsense”.

The inflation merry-go-round: The BIS sees two factors determining the inflation trajectory: commodity prices and the degree of slack in the economy. The commodity argument runs as follows: next to adverse supply shocks, food and energy prices have been buoyant because easy monetary policy has fuelled strong demand growth in emerging market economies. In addition, the search for yield due to very low interest rates has led to increased financial flows into commodities. Higher headline inflation due to surging commodity prices in turn has led to mounting wage pressures in some big emerging market economies, which are being transmitted to advanced economies via globalised supply chains. In essence, this is the global ‘inflation merry-go-round’ which we have described previously.

Cut the slack: The second part of the BIS argument will sound familiar to our readers, too. According to the BIS, traditional measures of the output gap, which still show a wide gap, may overestimate the amount of slack in the economy as the crisis is likely to have destroyed capacity permanently, especially in construction and finance. Hence, the output gap may be smaller than the traditional measures imply and inflationary pressures may thus be building earlier than generally believed. In fact, statistical BIS measures of the output gap show a much smaller or even positive gap than structural measures such as the one produced by the OECD .

Loose Tayloring individually… Against this backdrop, the BIS argues that policy rates are too low across the advanced and emerging economies. Using simple Taylor Rules for a large number of countries, the report shows that actual policy rates in many cases are far below the implied interest rates from the Taylor Rule – see the many observations above the 45 degree line in our illustration in the full report.

…and globally: Also, we illustrate that the aggregate global policy rate is lower than a global Taylor Rule would suggest, according to the BIS. Naturally, as we have emphasised in our own work on these issues, we would caution against reading too much into any particular measure of the output gap and, by implication, of the Taylor Rule, which uses a particular measure of the output gap. However, given the evidence of rising core inflation in the US since the October 2010 trough and in many other economies around the world, we side with the BIS assessment that there is probably less slack in the economy than meets the eye and that the global monetary policy stance is therefore excessively loose.

The lure of liquidity: As a consequence of extremely low interest rates, the BIS sees increased upside risks to global inflation, but also the risk of “creating serious financial distortions, misallocations of resources and delay in the necessary deleveraging”. It also worries about the signs of a renewed build-up of financial imbalances in some emerging market economies. We agree and would add another implication of very low interest rates: low borrowing costs in the major advanced economies take the market pressure off governments to address high budget deficits and rising public debt and may thus contribute to excessive complacency among fiscal policy-makers.

‘We hear you but we don’t listen’: Will the major central banks heed the BIS call for tighter policy soon? In our view, most of them (except the ECB) won’t, just as they all politely ignored the BIS warning about excessive credit growth and asset bubbles during the mid-2000s. Back then, the argument for doing nothing was that asset bubbles were difficult to diagnose, inflation was low and, if things went wrong, central banks could always mop up afterwards. Now the argument for doing nothing is that higher commodity prices and headline inflation are likely to be transitory, the bumpy, below-par and brittle recovery together with ample slack in labour and product markets will keep core inflation tame, and if wage pressures were to emerge, central banks would still have time to react after the fact. Given the uncertainty about the amount of slack in the economy, only time will tell which view is right.

Monetary policy has become complicated: But even if most central banks agreed with the BIS view that much tighter policy will be needed soon to quell global inflation pressures, this would not necessarily imply that they would follow through with aggressive rate hikes. The reason is that, rightly or wrongly, there are many other considerations besides inflation that influence monetary policy decisions these days. In the US, the Fed is explicitly mandated to pursue a dual objective: low inflation and sustainable employment. In the euro area, where the ECB is pushing rates higher now, financial and sovereign fragility will likely limit the room for manoeuvre. In many emerging market countries, the desire to prevent strong exchange rate appreciation in order to protect growth acts as a constraint on monetary tightening. And in the advanced economies in general, even though this may sound like heresy to many central bankers, political pressures due to high public sector debt should also make it difficult for central banks to raise interest rates aggressively. Despite their protests, central banks could benefit by reducing some of the burden of this debt by allowing inflation to erode its real value. Simply put, easier monetary policy might even be the optimal choice from this perspective, not just one that is forced upon central banks.

Central banks as problem solvers… In thinking about the challenges for monetary policy in this difficult post-bubble environment and the outlook for inflation, it is important to remember that central banks have usually been mandated and instrumentalized by their sovereigns to help alleviate whatever society viewed as the most pressing economic problem at any given time. Indeed, today’s (or yesterday’s) inflation-targeting mandates are unlikely to be the end of central bank history: they were merely the response to the ‘Great Inflation’ of the 1970s and 1980s, which had become the biggest public worry back then. And many central banks were made (more or less) independent over the past 20 years simply because this was seen as helping them to achieve their new price-stability mandates. Yet, history suggests that as the challenges change, so do central bank mandates. In fact, many central banks were founded centuries ago simply to help governments finance themselves through the printing press. Others, like the Fed in 1913, were established to serve as a lender of last resort, following the experience of the US financial panic of 1907. But even the Fed was mandated to help finance the government in 1942 when the US entered the war and then kept engineering negative real interest rates in the post-war years in order to help reduce the debt accumulated during the war.

…means higher global inflation eventually: So, history suggests that central banks will always be called upon to help address their respective societies’ most pressing economic problems. In today’s post-bubble world, these include high and persistent unemployment, financial fragility and high and rising public debts. Inflation, by contrast, does not seem to be high on most people’s worry list, despite the BIS concerns. Therefore, many major central banks are unlikely to heed the BIS call, global policy rates are likely to stay low for longer, and global inflation pressures look set to rise over the medium term, in our view.

Source: Joachim Fels, Morgan Stanley, July 1, 2011.

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