Central banks ill-advised to deny bubble risk

IN its annual report released late last month, the Bank for International Settlements (BIS) warned that "euphoric" financial markets have become detached from reality and called for governments to end policies that risk fuelling unsustainable asset booms. BIS - which is known as the bank for central banks - said that even as economies struggle to recover from 2008-09's Great Financial Crisis (GFC), capital markets are "extraordinarily buoyant" thanks to the ultra-accommodative policies pursued by central banks and warned them not to fall into the trap of raising rates "too slowly and too late".

Worryingly, the response to the BIS report from leading central banks has been denial. On Monday this week, European Central Bank president Mario Draghi told the European Parliament that ultra-low interest rates have not fuelled asset bubbles and that "macroprudential" policies were the best defence against bubbles forming.

On Tuesday, US Federal Reserve chair Janet Yellen in her Congressional testimony reiterated that the Fed neither was responsible for asset inflation nor should it do anything about it other than to consider "macroprudential measures". When asked during the question and answer session that rather than stop bubbles through regulation, it might be better not to have policies that created bubbles in the first place, Ms Yellen said that ultra-low interest rates are needed with the economy performing below its potential, employment below its maximum and inflation remaining below its target. Moreover, she added, hiking interest rates would risk weakening the economy, which could in turn destabilise financial markets.