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BIS warns that 'debt trap' makes raising interest rates more dangerous

Section: Daily Dispatches

BIS: Ultra-Low Interest Rates Could Make Global Economy Permanently Unstable

By Szu Ping Chan
The Telegraph, London
Sunday, June 29, 2014

Ultra-low interest rates and the failure of policy to "lean against" the buildup of financial imbalances are in danger of making the global economy permanently unstable, the Bank for International Settlements has warned.

In its annual report, the Swiss-based "bank of central banks" spelled out the risks of relying too heavily on monetary policy to stimulate the economy. The BIS warned that central banks including the Bank of England and US Federal Reserve could keep monetary policy loose for too long, with potentially damaging consequences.

"The prospects for a bumpy exit together with other factors suggest that the predominant risk is that central banks will find themselves behind the curve, exiting too late or too slowly," the BIS said today.

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It added that a "persistent easing bias" by fiscal, monetary, and prudential policymakers had lulled governments "into a false sense of security" that delayed needed consolidation and created a risk that instability could "entrench itself" in the system. "Policy does not lean against the booms but eases aggressively and persistently during busts," the BIS said. "This induces a downward bias in interest rates and an upward bias in debt levels, which in turn makes it hard to raise rates without damaging the economy -- a debt trap.

"Systemic financial crises do not become less frequent or intense, private and public debts continue to grow, the economy fails to climb onto a stronger sustainable path, and monetary and fiscal policies run out of ammunition. Over time, policies lose their effectiveness and may end up fostering the very conditions they seek to prevent."

Claudio Borio, the head of the BIS's monetary and economic department, warned that the onset of another financial crisis could trigger a retreat towards protectionism that would "spell the end to the current open global economic order" as we know it. "Focusing our attention on the shorter-term output fluctuations is akin to staring at the ripples on the ocean and losing sight of the more threatening underlying waves" he said.

The BIS noted that Britain's property market had been "unusually buoyant" and described the recent growth spurts in the UK and US as "somewhat unsettling" and akin to those observed just before financial crashes.

Mr Borio said policies were needed to "tame the financial cycle" and lean against financial booms rather than just "ease aggressively and persistently during busts".

The BIS highlighted the importance of clear communication as central banks moved towards tightening monetary policy. Bank of England Governor Mark Carney has said that interest rate increases will be "gradual and limited", and are likely to settle at around 2.5pc.

However, the BIS report noted that "Taylor Rule" implied rates in the UK showed interest rates should already be around 1.5 percentage points higher than their current level of 0.5pc.

John Taylor, Stanford economist and namesake of the rule, which presents a straightforward guideline as to how central banks should move interest rates in response to inflation, told the Telegraph that a shift away from "rules-based" policies at the beginning of the 21st century had made policymaking more opaque. He urged central banks to "lay the groundwork" for their return.

"If the [ interest rate] policy had been different for quite a while I think the economy would be stronger and you wouldn't think about anything but higher interest rates," he said. "Where it is now, you just have to go more slowly.

"I would not say interest rates should rise this week or this month, but policymakers should get back to a rules based policy, and one where people can see [where] interest rates should be given the economic conditions so they understand how policy works better.

"If you move gradually to a [higher] interest rate, money markets would work more like markets. ... These low rates cause a search for yield and risk-taking which is an imbalance and that could cause some problems down the road."

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