The Bank for International Settlements (BIS), the central bank umbrella body, has emphasized the need for further interest rate hikes, citing the crucial point at which the global economy finds itself as countries grapple with inflationary pressures.
Despite the persistent increase in rates over the past 18 months, inflation remains stubbornly high in many major economies, while the rise in borrowing costs has led to significant banking crises reminiscent of the financial crisis 15 years ago.
In its annual report published on Sunday, the BIS general manager, Agustin Carstens, stated that the global economy is at a critical juncture and that stern challenges must be addressed.
Carstens highlighted the need for monetary policy to restore price stability and for fiscal policy to consolidate, signalling a shift away from the previous focus on short-term growth.
Claudio Borio, the head of BIS’s monetary and economics unit, expressed concern about the emergence of an “inflationary psychology.” However, he noted that the recent rate hikes in Britain and Norway, which were larger than expected, demonstrated that central banks were determined to tackle the issue.
The challenges faced by central banks today are unique when compared to post-World War Two standards.
It is the first time that a surge in inflation has coincided with widespread financial vulnerabilities across much of the world.
According to the BIS report, the longer inflation remains elevated, the more extensive and prolonged the required policy tightening will be.
The report also warned of the possibility of further problems in the banking sector, emphasizing that if interest rates reach levels seen in the mid-1990s, the overall debt service burden for top economies would be the highest in history.
The BIS annual meeting, where central bankers discussed the turbulent past few months, recently took place.
During this period, several U.S. regional banks, including Silicon Valley Bank, experienced failures, and Credit Suisse required emergency rescue, which happened in the BIS’s own backyard.
The BIS report revealed that historically, about 15% of rate hike cycles lead to severe stress in the banking system.
However, the frequency increases significantly when interest rates rise, inflation surges, or house prices experience sharp increases.
In some cases, the likelihood of stress in the banking system can reach as high as 40% if the private debt-to-GDP ratio is in the top quartile of the historic delivery at the time of the first-rate hike.
The current scenario meets these criteria due to high debt levels, a significant global inflation surge, and a substantial increase in house prices during the pandemic.
According to the report, it was estimated that the expenditure associated with providing support to aging populations would rise by around 4% and 5% of the gross domestic product (GDP) in advanced and emerging market economies, respectively, within the next two decades.
Without fiscal belt-tightening by governments, this would push debt levels above 200% and 150% of GDP by 2050 in advanced and emerging market economies, respectively, potentially even higher if economic growth rates decline.
In addition to the economic analysis, the BIS presented a “game-changing” blueprint for an evolved financial system in its report.
The blueprint envisions a future where central bank digital currencies and tokenized banking assets streamline and enhance transactions and global trade.
Carstens emphasized that policymakers now carry the responsibility to act, stressing the need to correct unrealistic expectations that have emerged since the Great Financial Crisis and the COVID-19 pandemic concerning the degree and perseverance of monetary and fiscal provision.
While the BIS believes that achieving an economic “soft landing” where rates rise without triggering recessions or major banking crashes is still possible, it acknowledges the complexity of the situation.
Bank of America analysts have calculated that there have been 470 interest rate hikes globally in the past two years compared to 1,202 cuts since the financial crash.
