Interest rates in the world’s leading economies should rise while conditions are good to avert the twin risks of rising inflation and trade imbalances that could destroy the remarkable strength of the world economy, the Bank for International Settlements has warned.
The central banker’s bank, based in Basel, Switzerland, also says that financial innovation may be dangerous, especially the wider distribution of credit risk using asset-backed securities. “More scepticism might be expressed about some of the purported benefits of having new players, new instruments and new business models,” it says in its annual report.
It adds that the “performance of the global economy over the last few years has been extraordinary” with high levels of growth in rich and poor countries alike. Inflation has been subdued in spite of rising commodity prices, low interest rates, and easy finance created by global trade imbalances.
But the bankers in Basel identify risks to these benign conditions. The first is rising inflationary pressures, with most major industrial countries producing to the limit of their potential, and less downward pressure on prices from emerging markets such as China.
Second, the US economy is still vulnerable to a housing-induced slowdown, which could spread to countries dependent on exports to it.
Third, the BIS remains concerned about global trade imbalances, embodied in the US trade deficit and corresponding surpluses in China, other emerging economies and oil exporters, which could lead to “disruptive exchange rate changes with potential implications for financial markets”.
Fourth, with financial markets “priced to perfection”, it worries that any fall in asset prices could be much nastier than the traditional risk models suggest.
The BIS has long warned of the dangers inherent in the world’s unbalanced economy but thinks the combination of risks means action is required. “Against a backdrop of concern about both overall global inflation and evidence of increasing financing imbalances in many areas, tighter monitoring and financial conditions would seem called for.”
It singles out the US, China and Japan for action in monetary policy. With its large trade deficit, the BIS thinks the US should bear a “particular responsibility for contributing to the moderation of global demand growth”.
China, it says, “seems to have a particularly large gap between actual interest rates and the ‘normal’ rate determined by the economy’s potential growth rate”.
And Japan’s recovery, alongside evidence of large capital outflows, which “might be having unwelcome effects elsewhere” provides grounds for the Bank of Japan to “continue to normalise interest rates gradually”.
The BIS also wants to see structural reform, including a willingness by China to allow the renminbi to rise, which would encourage a shift to non-tradable services in surplus countries, and the growth of tradable products in countries that have current account deficits.