Central banks in developed nations are confronting the limits of their ability to aid economic recovery as government efforts to strengthen their finances fall short, the Bank for International Settlements said.
“Central banks are being cornered into prolonging monetary stimulus as governments drag their feet and adjustment is delayed,” the Basel, Switzerland-based BIS said in its annual report, published yesterday. “Both conventionally and unconventionally accommodative monetary policies are palliatives and have their limits.”
While central banks’ actions were key to limiting damage from the collapse of Lehman Brothers Holdings Inc., interest rates are now “as low as they can go” and debt purchases have swollen central bank balance sheets, the BIS said. European Central Bank President Mario Draghi has indicated that the ECB is close to exhausting its tools after cutting its benchmark rate to a record low and flooding the banking system with cash.
“In the middle of all this we find the overburdened central banks, pushed to use what power they have to contain the damage,” Stephen Cecchetti, BIS economic adviser, said on a conference call. “There are very clear limits to what central banks can do. It’s critical for the health of the global economy to break the vicious cycles and reduce the pressure on central banks.”
The BIS was formed in 1930 and acts as a central bank for the world’s monetary authorities. It said extraordinary measures have reduced incentives for politicians and other borrowers to repair balance sheets, and created the illusion that central banks can do much more to stoke growth and redress imbalances.
Central bank policy “buys time” in the short term for banks and governments to tackle debt overhangs, the BIS said. European finance ministers meeting in Luxembourg last week battled over strategies to contain the debt crisis. Leaders are due to hold a summit on June 28-29, which will be their 19th since the turmoil erupted.
The Federal Reserve expanded its Operation Twist program last week and will swap $267 billion in short-term securities with longer-term debt. Chairman Ben S. Bernanke said officials are focusing “primarily” on the outlook for jobs in deciding on further easing. The ECB has lent more than 1 trillion euros ($1.26 trillion) at its benchmark rate, and said this month it will continue to provide liquidity to solvent banks.
The benchmark rates of both banks, along with the Bank of England’s, are at a record low. Overall, central bank assets are at $18 trillion, about 30 percent of global gross domestic product, double the ratio a decade ago, according to the BIS.
“As the benefits of extraordinary monetary easing shrink and become less certain, the risks of expanding central bank balance sheets are likely to grow,” Jaime Caruana, general manager of the BIS, said in prepared remarks for a speech in Basel yesterday. “Such hazards may materialize in ways that are not completely clear today.”
Loose policy also poses risks for developing nations by fueling credit- and asset-price booms, complicating efforts to stabilize price gains, the report said. In emerging economies, interest rates have been raised “only hesitantly” out of concerns about stoking further capital inflows.
“As a result, monetary policy in emerging-market economies may be systematically too loose,” the BIS said. “This creates risks of rising financial imbalances” similar to those in advanced economies before the crisis.
The BIS called on central banks in advanced economies to take account of these spillover effects, and use all opportunities to encourage balance-sheet repair and deleveraging. Still, they “may have no choice but to keep monetary policy relatively accommodative for now.”
As central banks enter “uncharted territory” with their stimulus measures, policy makers may find it difficult to implement the required tightening of fiscal policy, Caruana said. Central banks might also lose credibility if governments fail to improve their balance sheets, he said.
“If markets come to see monetary policy decisions as constrained by the growing financing needs of government, the ability of central banks to control inflation would, at some point, be seriously compromised,” Caruana said. “Fiscal consolidation is therefore essential not only to restore fiscal sustainability, but also to preserve the credibility of monetary policy.”
On the debt crisis in Europe, the BIS said it’s “hard to escape” the conclusion that the solution to the crisis will have to include a pan-European banking system.
“A currency union that centralizes the lender of last resort for banks must unify its banking system,” it said. “Banks in Europe must become European banks.”
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