The Bank for International Settlements warned on Monday that central banks might need to raise interest rates even before their respective economies are clearly in recovery.

The so-called “central banks’ central bank” issued the warning because of fears that rates held low for a long time can have dangerous unintended consequences, including distorted investment decisions and market participants taking on bigger risks in their pursuit of higher yields.

The conclusions on monetary policy are contained in the BIS’s annual report that looks closely at what has happened in various countries when interest rates were held low for relatively long periods of time.

While policymakers need to use other tools to address some of the risks, the BIS concludes that “they may still need to tighten monetary policy sooner than consideration of macroeconomic prospects alone might suggest”.

The report also comes down firmly on the side of those who argue that in spite of the evident fragility of economic recovery in many industrial nations, governments need to address burgeoning fiscal deficits.

The issue was a dominant one at the G20 meeting over the weekend, with Europe and the US divided over the balance between austerity and fiscal stimulus measures. The gathering ended with all countries agreeing to halve their deficits by 2013 and stabilise the ratio of debt to gross domestic product by 2016.

“A programme of fiscal consolidation – cutting deficits by several percentage points of GDP over a number of years – would offer significant benefits of low and stable long-term interest rates, a less fragile financial system and, ultimately, better prospects for investment and long-term growth,” the BIS says.

It is understood that much of the report was written before heightened fears about sovereign debt in Europe roiled money markets and caused inter-bank lending to seize up. Nevertheless, the BIS makes clear that its concerns remain about the side-effects of a long-term spell of low rates.

Among the distortions associated with rates held low for a long time are asset price bubbles of the type that manifested themselves in the years before the financial crisis, particularly in housing and real estate in many countries. And because low central bank rates lead to low interest rates at the shortest maturities, banks and investors may be encouraged to engage in duration mismatch – borrowing short and lending long – a tactic that can destabilise the financial system if liquidity suddenly dries up.

Moreover, low interest rates make it easier for banks to engage in “evergreening”, the term the BIS uses to describe the practice of rolling over debt to non-viable businesses that can continue on interest payments at low rates but cannot afford to repay prinicipal.

This delays the necessary restructuring not only of the financial sector but also of other, inefficient industries, the report says.

It also notes that low interest rates may inadvertently contribute to instability in financial institutions, which in spite of massive government interventions, remain fragile “Cutting interest rates to record lows was necessary to prevent the complete collapse of the financial system and the real economy, but keeping them low for too long could also delay the necessary adjustment to a more sustainable economic and financial model.”

The report also looks at fiscal deficits in several countries that appear to be spiralling out of control, and in particular, those associated with age-related spending in economies where demographic shifts are tilted towards older adults. It notes that while extraordinary support measures have been necessary to contain contagion across markets, these cannot remain in place for too long.

“Some measures have delayed the needed adjustments in the real economy and financial sector where the reduction of leverage and balance sheet repair are far from complete,” the BIS report says, adding that the effect of this risks undermining confidence.

If anything, the failure to undo extraordinary measures threatens “to send the patient into relapse and to undermine reform efforts”.

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