"Of What Use Is A Gun With No Bullets?", BIS Says Central Banks Defenseless Against Coming Crisis

If you know anything about the history of the BIS, you know that the bank’s latest annual report is glaringly ironic and somewhat hypocritical. The “bank for central banks” as the highly profitable institution is known, has for decades served as a secretive club for the world’s most influential central bankers. The lavish governors’ weekends hosted by the bank in Basel allow the world’s most powerful monetary policy mavens to discuss the most important issues facing the global financial system in complete privacy with no fear that anything will leak to the public or to the press.

In other words, the BIS serves to encourage and perpetuate the power and prestige of the world’s central bankers and provides a top secret forum for the monetary policy cabal to meet and commiserate safe at all times from the prying eyes of those to whom the bankers should by all rights be accountable. 

In this context it’s somewhat absurd that the bank’s annual report — which, as a reminder, is required reading in treasury departments and monetary policy circles around the globe — contains a scathing critique of the very same policies which were no doubt devised, tweaked, and honed over dinner and fine wine in Basel. Nevertheless, the BIS’ latest tome is replete with criticism for the idea that the very people who make up the bank’s Board of Governors are indeed omnipotent. 

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Excerpted from the BIS Annual Report

Policies have been unable to constrain the build-up and collapse of damaging financial booms, ie the global economy exhibits “excess financial elasticity” – think of an elastic band that can be stretched out further and further until, eventually, it snaps back more painfully. 

The interaction of monetary regimes has spread the easing bias from the core economies to the rest of the world. This happens directly, because key international currencies – above all, the US dollar – are extensively used outside the issuing country’s borders. Thus, the core countries’ monetary policies directly influence financial conditions elsewhere. More importantly, an indirect effect works through the aversion of policymakers to unwelcome exchange rate appreciation. As a result, policy rates are kept lower and, if countries resort to foreign exchange intervention, yields are further compressed once the proceeds are invested in reserve currency assets.

All this raises the fundamental question that lies at the heart of the current policy debate: Why are market interest rates so low? And are they “equilibrium (or natural) rates”, ie are they where they should be? How are the market and equilibrium rates determined? 

Inflation need not reliably signal that rates are at their “equilibrium” level. Rather, the key signal may be the build-up of financial imbalances. After all, pre-crisis, inflation was stable and traditional estimates of potential output proved, in retrospect, far too optimistic. If one acknowledges that low interest rates contributed to the financial boom whose collapse caused the crisis, and that, as the evidence indicates, both the boom and the subsequent crisis caused long-lasting damage to output, employment and productivity growth, it is hard to argue that rates were at their equilibrium level. This also means that interest rates are low today, at least in part, because they were too low in the past. Low rates beget still lower rates. In this sense, low rates are self-validating. Given signs of the build-up of financial imbalances in several parts of the world, there is a troubling element of déjà vu in all this.

Shifting the focus from short-term to long-term rates does not change the picture. There is no reason to presume that these long-term rates will be at their equilibrium level any more than short-term rates are. Central banks and market participants fumble in the dark, seeking either to push rates towards equilibrium or to profit from their movement. After all, long-term rates are just another asset price. And asset prices often do follow unsustainable and erratic paths, as when they are at the root of financial instability.

What are the policy implications of this analysis? The first is that monetary policy has been overburdened for too long, especially post-crisis. The second, more general one, is the need to rebalance policies away from aggregate demand management to initiatives that are more structural in character. 

What to do now? Room for manoeuvre in macroeconomic policy has been narrowing with every passing year. In some jurisdictions, monetary policy is already testing its outer limits, to the point of stretching the boundaries of the unthinkable. In others, policy rates are still coming down. Fiscal policy, after the post-crisis expansion, has been throttled back, as sustainability concerns have mounted. And fiscal positions are deteriorating in EMEs where growth is slowing. What, then, should be done now, besides redoubling reform efforts to strengthen productivity growth?

For monetary policy, there is a need to fully appreciate the risks to financial and hence macroeconomic stability associated with current policies. True, there is great uncertainty about how the economy works. But precisely for this reason it seems imprudent to push the burden of tackling financial stability risks entirely onto prudential policies. As always, the correct calibration will be country-specific. But, as a general rule, a more balanced approach would mean attaching more weight than hitherto to the risks of normalising too late and too gradually. And, where easing is called for, the same should apply to the risks of easing too aggressively and persistently. 

Given where we are, normalisation is bound to be bumpy. Risk-taking in financial markets has gone on for too long. And the illusion that markets will remain liquid under stress has been too pervasive (Chapter II). But the likelihood of turbulence will increase further if current extraordinary conditions are spun out. The more one stretches an elastic band, the more violently it snaps back. Restoring more normal conditions will also be essential for facing the next recession, which will no doubt materialise at some point. Of what use is a gun with no bullets left? Therefore, while having regard for country-specific conditions, monetary policy normalisation should be pursued with a firm and steady hand.

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As you can see, the BIS is now pounding the table on the irresponsible actions of the bank's own board members. The celebrated monetary policy "bazooka" is out of ammunition even as the imbalances, excesses, and outright speculative bubbles post-crisis central bank policy has helped to create appear set to boil over. That is, the "rubber band" — to use the BIS' analogy — has been stretched farther than ever before and now threatens to snap back violently, only this time around, the world's central banks, having driven rates below zero and having monetized everything that's not tied down from USTs to German Bunds, to Japanese ETFs, to shares of Apple, will have no recourse. 

In sum, central banks have sown the seeds of their own destruction by failing to acknowledge their limitations, setting the stage for a tragically absurd endgame wherein central bankers suddenly realize that bringing every tool in the monetary tool box to bear on financial markets has created the conditions for a collapse which they will be unable to arrest precisely because any and all emergency measures were exhausted in the frantic attempt to reflate the last centrally planned bubble. 

We may not have to wait long for the day of reckoning because as we saw last week with Sweden, the game is now officially up.