By Central Bank News
The benefits from additional monetary stimulus by central banks in advanced economies are shrinking while the risks are likely growing, Jaime Caruana, general manager of the respected Bank for International Settlements (BIS) said.
Central banks have been highly successful in driving down long-term interest rates to help stimulate economic recovery, but the success can create unrealistic expectations of the power of central banks, warned Caruana in a speech to the annual meeting of BIS in the Swiss border city of Basel.
“Monetary policy can buy time needed for other policies to correct fundamental balance sheet problems. But even in this transitory role, monetary policy is not without limits or risks. Under current circumstances, the benefits of continued monetary easing cannot be taken for granted,” he said.
Central banks responded to the global financial crises in 2008 by slashing interest rates to near-zero and extended loans to prevent liquidity in the banking system from drying up, moves that helped the world from plunging into another 1930-style depression.
“But such results can create unrealistic expectations about the power of central banks. Monetary policy cannot resolve the fundamental problems that hold back sustainable growth. The root causes of the crisis are structural and fiscal, and only structural and fiscal reforms can bring the global economy back to sustainable growth,” Caruana said.
Faced with continued financial instability and sluggish growth as governments fail to tackle the thorny structural issues, central banks have drawn on their arsenal of weapons to support economies: Purchasing government bonds or private assets, pledging to maintain low policy rates, keeping liquidity flowing in banking systems by relaxing the quality of collateral or intervening in foreign exchange markets.
As a result, central banks’ balance sheets are exploding.
“Since the start of this crisis, the total assets of five major central banks in the advanced economies have grown to more than $9 trillion, or over 13% of world GDP, and now stand at more than double the pre-crisis average of almost $4 trillion,” he said.
The U.S. Federal Reserve, for example, now holds 11 percent of total outstanding debt and the Bank of England holds more than 18 percent of U.K. public debt.
“The unprecedented size of their balance sheets has brought central banks into uncharted territory. With no history to rely on, they will find it difficult to calibrate and implement the tightening of monetary policy that will inevitably be required,” Caruana said.
“The unprecedented size of their balance sheets has brought central banks into uncharted territory. With no history to rely on, they will find it difficult to calibrate and implement the tightening of monetary policy that will inevitably be required,” Caruana said.
With interest rates already at rock bottom, the benefits of further monetary stimulus is questionable.
“As the benefits of extraordinary monetary easing shrink and become less certain, the risks of expanding central bank balance sheets are likely to grow. Such hazards may materialise in ways that are not completely clear today,” Caruana said, outlining four hazards from central banks’ easy money.
Firstly, low interest rates makes it seem less urgent for borrowers and governments to cut debt. And continued high debt, increases the dependence on central banks.
Secondly, there are significant risks to financial stability. Earnings in the financial sector could be undermined and with low earnings there is an incentive to place risky bets. Large exposure to interest rates by banks may also be used as an argument for keeping interest rates down.
Thirdly, the exit from easy monetary policy could be “mis-calibrated or mis-communicated,” Caruana said. Although central banks have the tools to withdraw the excess reserves, there is a risk that central banks are too slow in tightening and excess bank reserves could lead to a sudden, unanticipated expansion of bank credit.
“Even if these dangers are successfully avoided, communicating with the public in a convincing way will still be very challenging in such unprecedented circumstances,” he said.
Fourthly, if financial markets believe that monetary policy is subject to the growing needs of government, the ability of central banks to control inflation could be compromised.
“Fiscal consolidation is therefore essential not only to restore fiscal sustainability, but also to preserve the credibility of monetary policy. This credibility, built up over the past two decades, has proved its worth during the crisis. It must not be squandered,” Caruana said.
Secondly, there are significant risks to financial stability. Earnings in the financial sector could be undermined and with low earnings there is an incentive to place risky bets. Large exposure to interest rates by banks may also be used as an argument for keeping interest rates down.
Thirdly, the exit from easy monetary policy could be “mis-calibrated or mis-communicated,” Caruana said. Although central banks have the tools to withdraw the excess reserves, there is a risk that central banks are too slow in tightening and excess bank reserves could lead to a sudden, unanticipated expansion of bank credit.
“Even if these dangers are successfully avoided, communicating with the public in a convincing way will still be very challenging in such unprecedented circumstances,” he said.
Fourthly, if financial markets believe that monetary policy is subject to the growing needs of government, the ability of central banks to control inflation could be compromised.
“Fiscal consolidation is therefore essential not only to restore fiscal sustainability, but also to preserve the credibility of monetary policy. This credibility, built up over the past two decades, has proved its worth during the crisis. It must not be squandered,” Caruana said.
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