Sound The Trumpet : BIS Warns Low Interest Rate Policies May Generate Next Global Financial Crisis

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“BIS Warns Low Interest Rate Policies May Generate Next Global Financial Crisis”
by ABC News
June 30th, 2014

Federal Reserve Board Chair Janet Yellen speaks at a quarterly news conference.

The international body representing central banks is warning its members that record low interest rates are generating conditions for another global financial crisis that may be worse than the first.

In its annual report, the Swiss-based Bank for International Settlements (BIS) expressed serious concern that global share markets had reached new highs and the interest rate premium for many risky loans had fallen.

"Overall, it is hard to avoid the sense of a puzzling disconnect between the markets' buoyancy and underlying economic developments globally," the bank wrote.

The BIS says the disconnect is largely due to continued monetary stimulus in the form of money printing and record low interest rates by many developed economy central banks.

"Financial markets have been exuberant over the past year, at least in advanced economies, dancing mainly to the tune of central bank decisions," it observed.

"Volatility in equity, fixed income and foreign exchange markets have sagged to historical lows. Obviously, market participants are pricing in hardly any risks."

This has led to another run up in global debt, with private debt outside the banking sector now 30 per cent bigger than it was before the financial crisis.

Of even more concern to the BIS than the total size of the debt is where it has gone, with many signs that risk is again being under-priced and finances being misdirected to speculative asset booms - just as it was in the run up to what the bank calls the Great Financial Crisis (GFC).

"Tellingly, growth has disappointed even as financial markets have roared: the transmission chain seems to be badly impaired," the bank lamented.

It is a warning central banks and market participants should heed, as the BIS was one of the only major international financial organisations to warn of the GFC before it began.

'Window of opportunity' to raise rates

Given the role of record low rates in generating financial risks, the BIS says that a recent upturn in the global economy is "a precious window of opportunity that should not be wasted" to start returning interest rates to more normal levels, while also putting other measures in place to temper booms.

The BIS accuses many of its major economy members of focusing on the short-term health of their economies, while failing to consider the long-term effects of their policies.

"Focusing our attention on the shorter-term output fluctuations is akin to staring at the ripples on the ocean while losing sight of the more threatening underlying waves," warned the bank's head of economics, Claudio Borio, in a briefing on the report.

The BIS warns that the fundamental failure of central banks and governments to deal with the underlying causes of the previous financial crisis is allowing the risk of a "bigger one down the road".

It says continued debt accumulation over successive business and financial cycles is at the root of the problem.

The bank argues that this debt accumulation has been largely caused by policymakers failing to lean against the booms but easing "aggressively and persistently" during busts.

The road ahead may be a long one. All the more reason, then, to start the journey sooner rather than later.

This growing mountain of debt is making it harder for economies to grow at higher interest rates, forcing central banks into a downward spiral of record low rates and monetary stimulus that simply encourages more borrowing, worsening the underlying problem - what the BIS labels "a debt trap" where, in effect, "low rates validate themselves".

"In contrast to what is often argued, central banks need to pay special attention to the risks of exiting too late and too gradually," the BIS report argues to its central bank members.

"The benefits of unusually easy monetary policies may appear quite tangible, especially if judged by the response of financial markets; the costs, unfortunately, will become apparent only over time and with hindsight."

These comments appear particularly directed at the US Federal Reserve, which just under a fortnight ago told markets that official rates were likely to remain near zero for "a considerable time" after it stops its bond buying stimulus program later this year.

The BIS also appears to take issue with such so-called forward guidance by the Fed.

"Seeking to prepare markets by being clear about intentions may inadvertently result in participants taking more assurance than the central bank wishes to convey," it warned.

"This can encourage further risk-taking, sowing the seeds of an even sharper reaction."

The BIS report may also be firing a shot across the bow of European Central Bank (ECB) president Mario Draghi, who is considering launching a continental version of the Fed's "quantitative easing" to boost the availability of cheap euros.

The bank played down the menace of deflation, the threat of which is the ECB's main justification for proposing further unconventional monetary stimulus.

"Few are ready to curb financial booms that make everyone feel illusively richer. Or to hold back on quick fixes for output slowdowns, even if such measures threaten to add fuel to unsustainable financial booms," the BIS bemoaned.

"The road ahead may be a long one. All the more reason, then, to start the journey sooner rather than later."

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