The Bank for International Settlements is worried

The jump in oil prices when global liquidity is high presents a dilemma for central banks, the BIS said in its annual report. This is strikingly reminiscent of conditions in the late 1960s and early 1970s that led to stagflation -- a combination of stagnant economies and high inflation -- it said. The U.S. Federal Reserve might have to speed up its monetary tightening to combat inflationary pressures from rising asset prices such as housing, the BIS said.

Inflation has been consistently over-predicted by central banks in the 1990s and 2000s, which has been a disinflationary period. This suggests changes in the structure of the economy, probably from globalisation, that are not fully accounted for in forecasting models. This is the opposite of what happened in the late 1960s and early 1970s, when forecasters consistently under-predicted inflation, reflecting outdated economic measuring methods. In particular the output gap and productivity was over-estimated at that time.

Market interest rates and central bank official rates today appear well below levels required to allow sustainable growth without inflation. This could reflect new dynamics at play in a deregulated financial system with new products and global capital markets that are not fully understood.

A series of booms and busts in credit and asset prices has emerged over the past 30 years, and the current global economy appears well into a third asset boom, demonstrated by heated housing and credit markets. This boom-bust cycle was supposed to have been eliminated by the achievement of price stability, BIS said.

These factors present practical challenges for central bankers, BIS said. They raise questions such as whether a central bank should cut rates more aggressively if inflation falls below its target, because domestic prices in a globalised economy are less sensitive to domestic demand.

Other questions raised are how a central banker should weigh the impact on already strong credit growth when deciding whether to lower interest rates further. Also how does a central bank handle the timing and size of rate increases when household indebtedness is high? It cited Australia as an example here. A similar factor faces the United States.

While past mistakes are unlikely, these new risks require central bankers to "be alert to the possible emergence of risks from unexpected quarters," the BIS concluded.



Categories: interest rates, economy