Monday, February 25, 2013
Era of 'benign neglect' of long-term rates over - BIS paper
Central banks typically target short-term interest rates to control inflation and economic activity and have relied on financial markets to take care of long-term rates to stabilize the economic cycle.
But this framework – described as ‘benign neglect’ by Philip Turner of the Bank for International Settlements (BIS) – is now over as central banks in most advanced economies have loaded up with government bonds since the Global Financial Crises, driving down real rates to negative in an effort to stimulate economic growth.
“Yet given high government debt and the size of central bank holdings the question of what should be the policy framework for the long-term interest rate is bound to become more prominent,” writes Turner in the latest working paper from Swiss-based BIS entitled “Benign neglect of the long-term interest rate.”
There are clear advantages to low long-term rates, including stimulating borrowing, repaying debt, making the financial system more resilient to shocks and allowing emerging economies to finance their infrastructure and housing needs more safely.
“But an extended period of very low long rates and high public debt creates financial stability risks,” writes Turner, adding that banks and some institutional investors face growing interest rate risks and central banks now hold a high portion of their own government bonds, most of which have failed to stop the rise in the debt-to-GDP ratio.
Illustrated by last week’s reaction in financial markets to the Federal Reserve’s January minutes, central banks’ exit strategy from their large holdings of government bonds will be controversial, complex and without precedence for markets to rely on.
“With massive government debt and uncertain fiscal prospects, it is very difficult for the private sector to know what to expect in the next few years. The extraordinary expansion in the balance sheets of central banks, which averted the danger of global depression, causes additional perplexity,” said Turner.
In his topical paper, Turner helps prepare the ground for the brewing debate over how long-term rates and government bonds should figure in central banks’ framework.
The latest installment of the debate will come in March, when the Federal Reserve’s policy body is set to review its asset purchase program followed by Federal Reserve Chairman Ben Bernanke's scheduled press conference March 20.
“Could a crisis force the authorities into sub-optimal choices? They will not be able to assume, as they had in the decade or so before the crisis, that the long- term rate will just take care of itself,” wrote Turner.