At midyear since the 1930s, punctually, the Bank for International Settlements has held its annual meeting of central bankers. The BIS management presents its audited accounts to its central bank owners; but the main story is a macroeconomic forum, the review of where the “real” economy stands, and what the financial system must do to support it. [1]
There is one reason why the BIS annual report is of greater significance than the more frequent, multilateral institutional studies: only central bankers can create money and determine its cost. This annual report is viewed by this community as the distillation of its collective intelligence: when virtually all the world’s central bankers look in the same direction and are analyzing the same sentences, WAIFC members ought to be investigating its meanings, too.
Introduction
The report headline is a bland expression of relief, “So far, so good.” The global economy is growing after Covid-19, and inflation is coming down in most parts of the world after the pandemic stimulus programs that were followed by commodities price shock caused by the war in Ukraine. The sense of the introduction is that things could have been worse.
But challenges remain. The stickiness of inflation in many jurisdictions means that the central bankers’ job is not yet done. Financial vulnerabilities have not gone away. Fragile fiscal positions cast dark shadows. Subdued productivity growth clouds economic prospects. Laying a more solid monetary foundation for the future is as difficult as ever. The BIS calls on central banks to keep their planning focus on a distant horizon, whatever the short-term pressures they must endure.
Pressure Points
The central scenario painted by professional forecasters and priced in financial markets is a smooth landing: more or less, price stability is restored, economic growth picks up, central banks ease, and the financial system remains strain-free. That would certainly be positive. But before the pandemic hit, the environment showed low inflation and rapid growth that relied on massive, ever-higher levels of debt, both public and private. That was a troubled inheritance.
These are the concerns:
- At the heart of the risks to inflation is the still partial adjustment of two closely related prices, those of services relative to those of core goods, and the price of real wages relative to goods and services. The pandemic interrupted the continual rise in the prices for services, because scarce goods shot up in value.
-The pandemic era also interrupted the steady rise in real wages. This lag could add to wage pressures ahead, especially given continued tightness in labor markets and slow productivity growth. To the extent that profit margins have benefited from surprise inflation, there should be room for adjustment.
-Macro-financial pressure points reflect the combination of higher interest rates and financial vulnerabilities in private sector balance sheets, in the form of high debt and stretched valuations.
-The banking strains in March 2023 occurred, in many cases, from interest rate risk, as higher interest rates shook valuations without causing borrowers to default. The effects of credit risk are still to come; the only question is when and how. Savings buffers are thinning. Debts will have to be refinanced.
-Commercial real estate has been on supervisors' radar screen for quite some time. The office segment has been hit by post-pandemic structural and cyclical forces.
-Banks are better capitalized than before the Great Financial Crisis. Their profits have also benefited from higher interest rates. The more lightly regulated parts of the non-bank financial sector remain a source of concern as stress amplifiers, owing to hidden leverage and liquidity mismatches.
-Fiscal trajectories represent one of the biggest threats to macroeconomic and financial stability in the medium- to long-term. The threat was masked by the long phase of exceptionally low interest rates, which had taken the debt service burden to new lows. In some cases, fiscal policy is still adding stimulus to the economy, acting at cross-purposes with monetary policy. Absent consolidation measures, debt ratios are set to climb. The financing needs of the green transition and geopolitical considerations have come on top of the burden of ageing populations.
-The wave of technological advances under way, notably AI, could significantly improve the productivity growth picture. Otherwise, low productivity would add to inflationary pressures, reduce the headroom for both monetary and fiscal policy, and, more generally, widen the gap between society's expectations and policymakers' capacity to meet them.
Policy Challenges
By far the top challenge is to complete the job of returning to price stability - while at the same time laying the financial foundations for sustainable and balanced growth for the long-term. This has implications for both policy settings and frameworks in the monetary, prudential, fiscal and structural domains.
Near-term policy settings
-The lessons learned since 2000 mean that central bankers must complete the work of disinflation with a steady hand, while keeping the room for policy maneuvers that central banks have finally regained. It would be wrong to cut based on the view that the "neutral" interest rate equates to the low-for-long rates that prevailed since 2008. Those rates must be seen as historically extraordinary.
-Divergence in the outlook for national interest rates will affect exchange rates and capital flows. Emerging market economies, in particular, are in a better position to address this than in the past, thanks to the build-up of foreign currency reserve buffers and stronger policy frameworks. This should provide greater room for maneuver in the fine-tuning of monetary policy, supported by careful use of FX intervention.
-The focus for prudential policy is resilience. There is still an opportunity to build up defenses for the credit losses that will inevitably materialize. On the macro prudential side, it would be important to avoid a premature easing of targets; policy should calibrate to financial cycle conditions. On the micro prudential side, tight supervision can temper risk-taking and help ensure adequate provisioning and realistic asset valuations. Should financial stress emerge, supervisors would need to act in concert with monetary and fiscal authorities to manage the strains while allowing monetary policy to focus on, as ever, stability.
-Fiscal policy must focus on consolidation. Full stop. This would relieve pressure on inflation, even if in the near-term any removal of remaining energy and food subsidies would raise prices.
Longer-term policy frameworks
Monetary policy frameworks have faced a series of extraordinary tests since the Great Financial Crisis. Central banks have limited the damage of financial crises, avoided major bumps in inflation until the pandemic, and created a solid basis for a return to price stability since.
Unless fiscal positions are brought under control, the threats to financial and macroeconomic stability will grow. The risk of global fragmentation, and the real costs of climate change and demographic trends could together make the supply of goods and services less elastic. Also to be watched, a return of persistent disinflationary pressures cannot be ruled out, especially if IT advances bear fruit.
What have central bankers learned since 2000 about the long game?
-Forceful monetary tightening can prevent inflation from transitioning to a high-inflation regime.
-Forceful action can stabilize the financial system at times of stress and prevent the economy from crashing, thereby eliminating a major source of deflationary pressures. The deployment of the central bank balance sheet does the heavy lifting, as the central bank is called upon to act as lender and, increasingly, market-maker of last resort. Central bankers also learned that those interventions, if repeated, can distort risk-taking incentives. Strengthening regulation and supervision is even more important to limit moral hazard.
-Exceptionally strong and prolonged monetary easing has limitations. Side effects include weakening financial intermediation, inducing resource misallocations, encouraging excessive risk-taking, and the build-up of vulnerabilities for central banks themselves as their balance sheets balloon.
-Communication has become more complicated. The multiplicity of financial instruments, public, private, and those of the central banks, makes it difficult to aggregate their effects and explain them clearly to the public. There is a growing gap in understanding just what central banks can and should do - they cannot deliver all that is expected of them without the simultaneous use of fiscal and regulatory tools. Central banks must do well what only they can do: ensure that monetary policy focuses on maintaining inflation within the region of price stability while safeguarding financial institutions’ solidity.
-The experience of emerging market economies has illustrated how complementary tools can help to improve the near-term trade-offs that monetary policy faces between price and financial stability. FX intervention allows the build-up of buffers that strengthen resilience and can attenuate swings in global financial conditions and exchange rates.
With a low-inflation regime, there is room for greater tolerance than in the past for moderate, even if persistent, deviations from narrowly defined targets. The additional room for policy slowly accruing would take advantage of the self-equilibrating properties of inflation, and reduce the side effects of keeping interest rates very low for extended periods.
Central banks need to pursue policies that retain policy room for maneuver over successive business and financial cycles. Zero and even negative rates did not allow for that. Exit strategies from extreme policy settings must be designed to stabilize the economy and keep balance sheets small and as riskless as possible. Since 2008, they have been massive buyers of assets that previously would not have met their credit and liquidity standards.
At certain times, the public must expect short-term costs for long-term benefits – the greater good is preservation of the value of currencies. This calls for communication strategies that reduce the pressure on central banks to do the easy but wrong thing. Safeguards for central bank independence are essential for the institutions to function, and for the public to retain its trust.
Monetary policy frameworks, however, are only one element of the broader policy setup.
Further efforts will be needed to strengthen prudential frameworks. It is essential to complete the Basel III framework, in a full, timely and consistent manner. It will be important to adjust regulatory and supervisory arrangements in the light of the evolving financial landscape and lessons drawn from episodes of financial stress, both recent ones and inevitable future ones. For prudential regulators, non-bank financial intermediation is the area that requires urgent action. Despite many post-Great Financial Crisis initiatives, a systemic stability-oriented macroprudential regulatory framework has proved beyond reach.
For WAIFC Members
The BIS has given the world a rich menu of questions and objectives for financial services industry leaders to debate. No remedy for problems in our evolving industry is workable without the political will to adopt it, and that requires marshalling public support – this is a perfect opening for WAIFC leaders. Implementing the necessary policy adjustments has arguably become harder since the Great Financial Crisis, as expectations of government support have grown. Information and communication matter even more.
For the “real economy,” political will is needed to revive the supply potential of the global economy. Only structural policies can deliver the productivity improvements needed to enable higher sustainable growth. Recognizing this point, in turn, calls for a broad change of mindset to dispel the deeply rooted growth illusion at the heart of the debt-fueled growth model that the world has relied on for too long. Again, information and communication are critical, and WAIFC members may well wish to step forward.
[1] https://www.bis.org/publ/arpdf/ar2024e_ov.htm