Central banks may have worsened the global financial crises by slashing policy rates in response to stock market crashes in 1987 and 2000, inflating a financial boom that ultimately collapsed years later, according to the Bank for International Settlements (BIS).
To avoid a repeat, BIS is calling for a radical change in worldwide monetary and financial policy.
Central banks should no longer just react to short-term fluctuations in economic output but take aim at the highly destructive force of the financial cycle as they ultimately move away from debt as the main engine of economic growth.
Unlike business cycles, which tend to last from one to eight years, financial cycles are much more slow moving and can last 15-20 years, with debt in a myriad of guises slowly building up while property prices steadily inflate.
Currently, the financial cycle is not on their radar screen of most central banks with the consequence that they often overreact to short-term changes in economic output and inflation, thereby generating bigger problems down the road, said the respected BIS in its annual report.
By cutting interest rates over successive business and financial cycles and only slowly raising them afterwards, an asymmetrical bias is created, with the risk of entrenching instability in the economy, said Swiss-based BIS, known as the central banks’ bank.
“Policy does not lean against the booms but eases aggressively and persistently during busts,” said BIS, describing how monetary policy in most countries is executed.
“This induces a downward bias in interest rates and an upward bias in debt levels, which in turn makes it hard to raise rates without damaging the economy – a debt trap.”
As an example of when monetary policy appeared to focus too narrowly on short-term developments, BIS pointed to the response to the 1987 and 2000 stock market crashes when policy was eased but then only gradually tightened.
“But the financial boom, in the form of credit and property price increases, gathered momentum even as the economy softened, responding in part to the policy easing,” BIS said.
The globalization of the economy then added strength and breadth to the financial booms, raising growth expectations, turbocharging the booms, while keeping a lid on prices, lessening the need to tighten monetary policy.
“For monetary policy, this means being ready to tighten whenever financial imbalances show signs of building up, even if inflation appears to be under control in the near term,” BIS said.
One of the features of financial cycles is that they are often synchronized across economies as mobile financial capital amplifies movements in credit.
“In the longer term, the main task is to adjust policy frameworks so as to make growth less debt-dependent and to tame the destructive power of the financial cycle,” BIS said.
Setting policy without regard to the financial cycle may result in financial imbalances, such as over-indebted corporate or household sectors or bloated financial systems that render sectors fragile to even a small change in conditions.
“This dynamic suggest that monetary policy should play a greater role as a complement to macroprudential measures when dealing with financial imbalances,” BIS said.
Another shortcoming of the current policy framework is the struggle by many emerging market economies and small open economies to deal with the spillover from years of easy monetary policy in advanced economies.
“It also points to shortcomings in the international monetary system, as global monetary policy spillovers are not sufficiently internalized,” BIS said.
The impact of one country’s monetary policy on other countries is commonly described as an international spillover. Currently, the doctrine of “the own-house-in-order” dominates, raising the risks for the global economy.
While some of the major central banks already look at how their actions impact other countries, BIS said the banks' analytical frameworks have to put financial booms and busts at the core of their assessments along with the myriad of financial interconnections to avoid underestimating policy feedback effects.
One component of a new policy framework is for central banks and authorities to ensure that buffers are built up during a financial boom – such as recently introduced by Norway – so they can be drawn down in a bust, making the economy more resilient to a downturn.
By allocating funds to the buffer, it also dampens the intensity of the boom, making monetary policy more symmetrical with respect to the boom and bust phases of the financial cycle and avoiding the progressive loss of policy room for manoeuvre over time.
For prudential policy, capital requirements or loan-to-value ratios – as instituted by New Zealand and now by the U.K. – should be adjusted to reduce procyclicality.
While central banks now largely recognize that price stability doesn’t guarantee financial stability and some have adjusted frameworks to include the option of tightening policy during booms by lengthening policy horizons, BIS acknowledged that there is differing views as to whether such adjustments are desirable.
One of the challenges for central banks is how to communicate the risks that slower-moving financial cycles pose as it may include a greater tolerance for short-run deviations from inflation objectives as well as for exchange rate appreciation.