Subprime lesson: raise rates when inflation low, BIS expert queries
BASEL (AFP) — Central banks should consider raising interest rates even when inflation is low, a top expert suggests before a meeting of central bankers here likely to focus on eight months of global financial crisis.
The breakdown of the US subprime home-loan market was merely the last straw that broke the financial system, and not the main cause, the expert at the Bank for International Settlements also says in a personal study of the crisis.
The analysis, in a series of regular working papers, draws some lessons, suggesting that central bankers should establish rules for rescuing financial markets so that those responsible can be made to pay a price.
The BIS, the forum for world central banking, holds its annual meeting on June 30. The study was written by the head of research and policy analysis, Claudio Borio, and released by the BIS on April 18.
He points a finger at credit rating agencies, arguing that ratings must improve, and says that incentive pay packages in the finance industry should be "more prudent."
But the most controversial passages concern arguments for central banks to be ready to raise rates even when inflation is under control, so as to minimise sharp correction of asset prices later and resulting instability.
The suggestion is sensitive because some political voices in the eurozone urged the European Central Bank to keep rates low, and objected when it began to raise them to counter future inflation, on the basis that inflation was under control.
Since then asset bubbles, notably in property markets, have undergone sharp corrections, as in the subprime crisis, and also raw materials prices have boomed.
Borio says that the drama repeated many aspects of past crises, indicating that such dynamics are inherent and that "each generation repeats the experience of its predecessors ... in considerable detail."
All such crises could be said to be rooted in excessive risk-taking in good times which "simply materialises in adversity."
An increase in the availability of funds, by containing interest rates, tends to push up asset prices. Monetary policy has a role to play in holding back this process, he suggests.
"The main challenge for monetary policy is that financial imbalances can also build up in the absence of overt inflationary pressures," he warns.
"The failure of inflation to rise may thus result in monetary authorities unwittingly accommodating the build-up of the imbalances ... failure to adjust may eliminate a welcome brake on this form of behaviour."
He comments: "This suggests that it is important for monetary policy frameworks to allow for the possibility of tightening monetary policy even if near-term inflation remains under control."
Central bankers had to trade off two risks. "One is responding too little too late. This is the more familiar risk, most commonly and spectacularly associated with the Great Depression."
The other is "responding too much too quickly and, above all, for too long."
The key was ensuring that liquidity was targeted at the interbank links most under strain.
Borio also refers indirectly to decisions by some central banks, and notably the US Federal Reserve, to accept unusually low-grade collateral in exchange for funding, and to the principle of "moral hazard," meaning that imprudent lenders must not expect a painless bail-out.
There are no such principles for dealing with the diffusion of responsibility when crises originate in markets, he says, but central banks are now studying this.
The crisis that broke on August 9 was caused only incidentally by the US subprime home-loan debacle, which was merely the last straw on the back of a system overloaded by a long run of high growth and low interest rates, he says.
It "turned out to herald much more serious dislocations at the very heart of the global financial system. With a bang, the current financial turmoil had announced its arrival," he says.
However the crisis evolves "it already threatens to become one of the defining economic moments of the 21st century."
"The unfolding market turmoil is best seen as a natural result of a prolonged period of generalised and aggressive risk-taking, which happened to have the subprime market at its epicentre."
The world economy had shown record growth from 2004 to 2006 coupled with "unusually strong performance in financial markets" and a strong rise in house prices which had boosted household spending.
Many types of asset appeared to carry "exceptionally low" risk. In a context of "historically low interest rates" and "booming asset prices,"the money supply increased rapidly.
Innovation in opaque financial instruments had accelerated rapidly in recent years, and it was against this overall backdrop that the crisis built up.
Inadequate credit ratings of so-called securitised or repackaged credit portfolios had contributed to the crisis by "lulling participants into a false sense of security" and when the storm broke, instead of distributing risk "now distributed fear."
Warning signals began to appear in May 2005 in the corporate credit market, and became clear in January 2007, two years after strains appeared in the subprime market.
Central banks in many couintries responded immediately by increasing funding available to the system to calm markets.
Borio warns that the injection of liquidity, and big cuts in short-term interest rates by the US Fed, might not settle the crisis "so easily".
This was partly because property prices would respond far more slowly than share prices. And there could be a lag of two to three years because "the worst credits are granted towards the peak of the boom."
