There is little doubt that central banks helped contain the fallout from the 2007-2009 financial crises, but it is just as clear that the recovery from the recession has been unusually sluggish despite seven years of rock-bottom interest rates.
“This suggests that monetary policy has been relatively ineffective in boosting a recovery from a balance sheet recession,” BIS said in its annual report.
One reason for the limited effectiveness of monetary policy is that once central banks, such as the U.S. Federal Reserve in December 2008 and the Bank of England in March 2009, have slashed rates to essentially zero, they can’t go lower.
But more importantly, the reason for the relative ineffectiveness of monetary policy is that the recession was not a typical postwar recession but rather a balance sheet recession that was associated with the bust of an outsize financial cycle.
“Balance sheet recessions are less responsive than normal recessions to policies that boost direct demand,” Claudio Borio, who took over as head of BIS' Monetary and Economic Department last November, told journalists in a telephone conference.
The hallmark of balance sheet recession such is a large overhang of debt, weakened financial institutions and misallocation of capital and labour, illustrated by the boom in U.S. construction and home building in the early 2000s.
With banks in need of restoring their balance sheets, they not only restrict lending but misallocate credit by continuing to lend to derelict borrowers to avoid recognizing losses while they cut back or make it more expensive for borrowers in better shape.
Encouraging indebted borrowers to borrow more via low interest rates or a boost from fiscal policy has little effect as they end up saving it and not spending it.
The financial crises mainly hit those countries that were experiencing an outsized financial cycle, such as the U.S., UK, Spain and Ireland, where the build up in debt by households and non-financial companies went hand in hand with systemic banking problems.
Other parts of the world, such as Canada and many emerging market economies, were mainly hit by the crises through trade linkages while countries such as Switzerland experienced serious banking strains through their banks’ exposure to financial busts in other countries.
Reflecting this more differentiated global view of the financial crises, the BIS now refers to the financial crises as the “Great Recession” rather the global financial crises as in past years.
Countries around the world now find themselves in different phases of domestic financial cycles.
While some are still grappling with the legacy of the financial bust, others are experiencing financial booms with rising property prices while debt levels remain high, partly stimulated by the spreading of easy monetary conditions in advanced economies.
For Borio - a pioneer in developing the understanding of the slower-moving financial cycles in contrast to the faster-moving business cycles - the recipe for returning to more sustainable growth is country-specific, depending on the stage of the financial cycle.
In countries that experienced the depth of the recession, balance sheets must be repaired with losses recognized along with targeted structural reforms that help the transfer of resources to productive sectors and away from unproductive sectors.
“More intensive repair and reform efforts would help relieve the huge pressure on monetary policy,” said BIS, noting the impact of low interest rates have less and less effect while the side effects loom larger.
Some of the side effects of very low interest rates is that they can postpone the adjustment of balance sheets by encouraging the evergreening of bad debts, damage the financial strength of institutions, favor risk taking and generate unwelcome spillovers to economies, particularly when financial cycles are out of synch.
There will be huge political and financial pressures on central banks in advanced economies to delay the exit from exceptionally easy policies, and regardless of central bank’s communication efforts, “the exit is unlikely to be smooth,” BIS said.
Seeking to prepare markets through policy guidance about its intentions can inadvertently encourage further risk taking.
A vicious circle can develop, with the central bank feeling boxed in for fear of precipitating exactly the sharp market reaction that it was seeking to avoid.
Markets may then react first, seeing the central bank as being behind the curve.
“This too suggests, that special attention needs to be paid to the risks of delaying the exit,” said BIS, echoing its message from last year's annual report that “market jitters should be no reason to slow down the process.”
In countries there financial booms are still under way, BIS said the pressing priority is to address the build-up of imbalances that threaten economic stability.
“As shown in May last year, the eventual normalization of US policy could trigger renewed market tensions,” BIS said. “The window of opportunity should not be missed.”
First, prudential policy should be tightened, especially through macroprudential tools, something many emerging markets have been using quite effectively, but BIS also called for monetary policy to work in the same direction to help constrain the booms.
With the rise in debt, the vulnerability of an economy to higher policy rates have risen.
“Particularly for countries in the late stages of financial booms, the trade-off is now between the risk of bringing forward the downward leg of the cycle and that of suffering a bigger bust later on. Earlier, more gradual adjustments are preferable.”
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