Flexibility at a premium for monetary policy as central banks face delicate balancing act: BIS

London

CENTRAL banks and governments around the world need to pursue "growth-friendly" policies as the global economy emerges from the pandemic.

The growth should help reduce the massive debt burden of both developed and emerging economies, said Agustin Carstens, general manager of the Bank for International Settlements (BIS) at its annual general meeting on Tuesday.

But to succeed in creating long term growth with minimal inflation, governments must carry out "structural reforms", he said.

These reforms include encouraging competition and productivity by encouraging new businesses to replace unprofitable firms and create more jobs. Simultaneously, governments should invest in education, healthcare and green infrastructure.

"Flexibility will also be at a premium for monetary policy. Central banks face a delicate balancing act," said the BIS in its report.

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"On the one hand, they need to reassure markets of their continued willingness to support the economy as necessary. On the other, they also need to reassure them of their anti-inflation credentials and prepare the ground for normalisation."

The BIS stressed that although recovery from the pandemic's recession has been "surprisingly strong, it is uneven and the long-term consequences material".

The report went on to say that BIS is aware of the economic and financial risks of the so-called "pandexit".

There are three potential future scenarios that could pan out.

The central scenario, embodied in current consensus forecasts, is that the recovery will be "comparatively smooth".

Consumption should sustain the expansion and corporate losses will be limited. Inflation in the large developed economies is rising, but any further increase will be temporary.

Supply shortages and logistical problems will abate. Longer term technological progress and globalisation will pull down prices. Under this economic forecast, "financial conditions will not tighten significantly".

There will, however, be significant economic outcomes between developed and developing nations, said BIS in its report.

They will "pandexit at their own speed and in their own way". In particular, growth in many emerging economies will lag and experience persistent inflation. Some are benefiting from commodity exports, others are struggling from the burden of food shortages and price rises.

The second scenario is that inflation "exceeds expectations on the back of stronger growth".

This takes into account large spending increases of many major economies including the US. Consumers keep drawing down savings that were accumulated during the pandemic and go on a shopping spree. As such, the pandemic abates and confidence surges.

The downside of this inflationary economic boom is that financial market participants might overreact. They anticipate higher and sustained inflation and expect central banks to tighten monetary policy substantially and raise interest rates.

Under this scenario, "dealers could be caught wrong-footed and be forced to unwind their positions".

"The prolonged aggressive risk-taking that has prevailed in markets for so long increases the probability of such an outcome," the BIS warned.

"Recent localised stress, such as the Archegos failure and the losses it has inflicted on banks, could turn out to be the proverbial canary in the coalmine of hidden leverage and liquidity mismatches," the report said.

"If inflation surprised on the upside and financial conditions tightened, central banks would be severely tested," said the BIS, adding that a "tug of war" between financial markets and central banks would probably ensue.

"Depending on views concerning the path of inflation and inflation expectations, the US Federal Reserve Board, in particular, would have to choose between being extremely patient, on the one hand, and adjusting the stance sooner than anticipated, on the other," said the BIS. "It would be difficult to avoid bouts of high volatility and tension in markets."

The tightening of financial conditions would have broader repercussions. Emerging market economies would be most vulnerable.

While initially benefiting from stronger economic growth and hence buoyant trade, they would subsequenly face tighter global financial conditions.

Should the US dollar also appreciate, the pressure would mount further, added the BIS. In short, the boom could be followed by financial turmoil and recession.

The third scenario, in which the recovery stalls, "is more plausible if the pandemic proves harder to control", the BIS said.

Successive waves of more virulent Covid-19 strains could be impervious to vaccines, leading to tighter containment measures. Infrastructure spending, other "fiscal multipliers" and consumer spending could fall short of expectations.

The "feared wave of firms' insolvencies could materialise" and be on a par with bankruptcies during the 2008 Global Financial Crisis.

The BIS said that a global slump in housing prices and corporate bond failures could accentuate the crisis and place banks under strain.

"This range of outcomes suggests that policy needs to be calibrated in a sufficiently flexible and prudent way in order to accommodate the resulting uncertainty," the BIS said.

Governments will continue to face the question of when and how far to withdraw stimulus, and central banks will have to either ease in a crisis and raise rates slowly and carefully to curb inflationary expectations, it said.