Bank for International Settlements Tells Central Banks to Reel In Policy Or Risk Credibility

The Bank for International Settlements (BIS) overnight issued its annual report in which it wrote a scathing review of global central banking policy. The BIS urged central bankers to reel in expansionary policies as delivering increasing amounts of stimulus becomes "increasingly perilous."

Operating On Borrowed Time

The BIS noted in the beginning of its report that central banks are simply buying time for governments to enact structural economic reforms. "What central bank accommodation has done during the recovery is to borrow time – time for balance sheet repair, time for fiscal consolidation, and time for reforms to restore productivity growth." However, they are cautious that this wait and see policy has negative consequences.

"But the time has not been well used, as continued low interest rates and unconventional policies have made it easy for the private sector to postpone deleveraging, easy for the government to finance deficits, and easy for the authorities to delay needed reforms in the real economy and in the financial system. After all, cheap money makes it easier to borrow than to save, easier to spend than to tax, easier to remain the same than to change."

"Delivering further extraordinary monetary stimulus is becoming increasingly perilous, as the balance between its benefits and costs is shifting. Chapter VI argues that policy frameworks anchored to price stability remain the foundation for growth. Without price stability, you have nothing. But, as the crisis has taught us, narrow near-term price stability is not enough: financial stability is also essential for long-term macroeconomic stability. The challenge is to modify traditional monetary policy frameworks to include financial stability considerations effectively and symmetrically."

Translation: central banks globally, including the Fed, have run the risk of reflating the credit bubble by shifting the euphoric bubbles out of credit markets and into the stock market, the bond market, and into commodities and emerging markets. The BIS believes that the risk of financial instability is ever-present and growing so long as central banks continue easy money policy and continue to expand balance sheets.

Fiscal Sustainability and Risks

A key risk to the global economy, aside from financial overheating, is the continued fiscal risk posed by over-leveraged public balance sheets. However, the BIS fears that only nations that have faced fiscal crises have made proper adjustments and that further crises will be the only catalysts for true fiscal adjustments.

"The largest adjustment has taken place in economies facing financial market pressures. Among the countries under EU-IMF financial support programmes, Greece is expected to have improved its underlying primary balance by almost 17 percentage points of potential GDP by the end of 2013, while Ireland and Portugal are expected to have improved theirs by 7.3 and 6.8 points, respectively."

The BIS even goes so far as to hint that the U.S. government absolutely needs to reform entitlements or risks having to reduce spending across the board by over 10 percent further, which would cause a steep recession. They note that "age-related expenditures" are out of control and need to be curbed. With reforms to these entitlement programs, they still suggest that the United States needs to lower its primary balance (budget balance ex-interest payments) by an additional 5 percentage points while the U.K. needs to improve by 7.4 percentage points. "Given their huge size, it is unlikely that such adjustments will be made, as governments will probably focus on redesigning entitlements."

The BIS also noted that fiscal adjustments are needed in other nations. They say that Spain needs to lower its primary balance by 7.8 percentage points and and Canada by 4.3 points while Italy needs a 4.2 percent adjustment and France needs a 3.6 percent adjustment.

Monetary Policy At a Crossroads

The BIS lastly points out that exiting from current monetary policy will not be easy for central banks globally. The report highlights that policy rates in advanced economies are on average about 2 percent below where they should be while in emerging markets, rates are nearly 4 percent below "normal" levels.

"Some of the issues are rather technical, although they may have significant implications for market functioning. One example is the payment of interest on reserves. This common practice was not available to the Federal Reserve before the crisis and is likely to be retained, as it improves the ability of the central bank to control short-term interest rates. A second, more delicate, point concerns the range of acceptable collateral."

"A more general issue is whether central banks should resume operating in the markets so as to influence only a short-term rate. This would mean shelving attempts to influence broader financial conditions more directly through, for instance, large-scale asset purchases or special lending schemes. If so, the short- term policy rate and expectations about its future path would again become the mechanism to steer monetary conditions."

Lastly, the BIS reinforces its point that the longer current policy conditions persist, the harder any eventual exit will be. They believe that it is this key dilemma that argues for structural and fiscal reforms now as a means to lessen the impact of any eventual monetary exit.