BIS Says Central Banks Need to Start Increasing Rates to Contain Inflation

Central banks need to start raising interest rates to control inflation and may have to act faster than in the past, the Bank for International Settlements said.

“Tighter global monetary policy is needed in order to contain inflation pressures and ward off financial stability risks,” the BIS said in its annual report published yesterday in Basel, Switzerland. “Central banks may have to be prepared to raise policy rates at a faster pace than in previous tightening episodes.”

While policy makers in Asia and Latin America are already raising borrowing costs to damp price pressures, rates remain near record lows in the world’s largest developed economies. Central banks in the U.S., U.K. and Japan have signaled they intend to keep that stimulus in place for some time, with only the European Central Bank moving to gradually tighten credit as inflation risks increase.

“Global inflation pressures are rising rapidly as commodity prices soar and as the global recovery runs into capacity constraints,” said the BIS, which acts as a central bank for the world’s central banks. “These increased upside risks to inflation call for higher policy rates.”

With U.K. inflation running at 4.5 percent, more than double the Bank of England’s target, the BIS said “one wonders how long its current policy can be sustained.” The pound rose half a cent in early European trading to $1.5985 before retracing to $1.5931 at 9 a.m. in London.

‘Too Low For Too Long’

Crude oil prices have gained 20 percent in the last 12 months, putting pressure on companies to increase wages and pass on higher costs to consumers.

“The price pressure is there,” said Carsten Brzeski, chief European economist at ING Group NV in Brussels. “One of the lessons of the financial crisis is that you shouldn’t leave rates too low for too long. Now is the time to remember that lesson.”

BIS General Manager Jaime Caruana said global headline inflation has risen a percentage point to 3.6 percent since April 2010. At the same time, short-term interest rates adjusted for inflation “have actually fallen in the past year, from minus 0.6 percent to minus 1.3 percent globally,” he said in a speech in Basel yesterday.

“The world economy is growing at a historically respectable rate of around 4 percent,” Caruana said. “The resurgence of demand has put concerns about deflation behind us. Accordingly, the need for continued extraordinary monetary accommodation has faded.”

‘Extended Period’

The ECB in April raised its benchmark interest rate from a record low of 1 percent and has signaled another quarter-point step is likely in July.

By contrast, the Federal Reserve last week repeated a pledge to keep its policy rate close to zero for an “extended period,” while the Bank of Japan this month held its benchmark near zero and kept credit and asset-purchase programs in place.

Minutes of the Bank of England’s last policy meeting this month, at which the key rate was held at 0.5 percent, show some officials see the potential to extend bond purchases to boost a faltering recovery.

The BIS said that in “some advanced economies” policy tightening still needs to be balanced against the “vulnerabilities” associated with balance-sheet adjustment and financial sector fragility.

Credibility

Still, “undue delay in the normalization of the monetary policy stance entails the risk of creating serious financial- market distortions,” it said. Furthermore, a “timely tightening” of policy in both emerging-market and advanced economies will be needed “to preserve a low-inflation environment globally and reinforce central banks’ inflation- fighting credibility.”

The BIS said central banks should reduce the size of their balance sheets, though it would be “dangerous” to cut them “too rapidly or too indiscriminately.”

In response to the financial crisis, the Fed and the Bank of England “sharply” increased their total assets from about 8 percent of gross domestic product to just below 20 percent, while the ECB expanded its assets from 13 percent of GDP to more than 20 percent, according to the BIS.

“Balance-sheet policies have supported the global economy through a very difficult crisis,” it said. “However, the balance sheets are now exposed to greater risks -- namely interest-rate risk, exchange-rate risk and credit risk -- that could lead to financial losses.”

‘Once And For All’

The BIS also urged governments to pursue fiscal consolidation, saying the biggest risk is “doing too little too late rather than doing too much too soon.” In Europe, policy makers must fix the region’s debt crisis “once and for all,” it said.

“Nowhere is the link between fiscal sustainability and financial health more apparent than in parts of Europe today,” Caruana said. “There is no easy way out, no shortcut, no painless solution.”

The BIS warned that a failure of the U.S. to tackle its budget deficit could become a source of instability, with potentially “far-reaching ramifications for the global economy” should a rapid depreciation of the dollar result.

“The current ability of the United States to easily finance its deficit cannot be taken for granted,” the report said.

The BIS holds currency reserves on behalf of its members and provides policy makers with a forum for discussion. Attendees at the annual general meeting in Basel yesterday included ECB President Jean-Claude Trichet, Fed Chairman Ben S. Bernanke, Bank of Japan Governor Masaaki Shirakawa and Bundesbank President Jens Weidmann.

To contact the reporters on this story: Christian Vits in Basel at cvits@bloomberg.net; Gabi Thesing in Basel at gthesing@bloomberg.net

To contact the editor responsible for this story: Matthew Brockett at mbrockett1@bloomberg.net

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