Central banks should continue to tighten interest rates but must tread carefully lest risk provoking a new financial crisis, according to the Bank for International Settlements (BIS).
In its 87th annual report, the umbrella group for central banks, warned that high levels of debt posed a risk to financial stability, despite signs that economic growth could soon recover to long-term averages.
BIS noted the strengthening in the global economy over the past year, with unemployment falling to pre-crisis levels and inflation rising towards long-term central bank targets.
At the same time, BIS noted that signs of lessening economic slack suggested that the current economic expansion was reaching a more mature phase.
High debt levels
In particular, BIS highlighted the risks presented by high levels of private debt and elevated house prices across several economies.
“High household debt might become a drag on demand in some countries, especially if rising interest rates were to boost debt service burdens,” warned BIS.
The central bankers´ body also claimed that high levels of corporate debt combined with weak growth in productivity risked becoming a drag on investment.
Central bank dilemma
The BIS report highlighted the dilemma for central banks as they attempt to unwind accommodative monetary policy and tighten interest rates.
“Policy normalisation presents unprecedented challenges, given the current high debt levels and unusual uncertainty. A strategy of gradualism and transparency has clear benefits but is no panacea, as it may also encourage further risk-taking and slow down the build-up of policymakers' room for manoeuvre,” said the report.
While BIS notes that a reduction in labour market slack has raised the prospect of higher inflation ahead, it does not expect the latter to become the primary threat to the ongoing expansion in the global economy.
Central bankers though, could be storing up problems for the future if they delay normalising their monetary policy. BIS highlighted how central banks´ balance sheets had remained large or even grown further over the past year.
At the same time, BIS claimed the financial sector continued to face challenges despite some improvement in the near-term economic outlook. In short, BIS is not convinced that enough has been done for a financial crisis not to be repeated. It points to concerns that the banking sector is still over-reliant on short-term borrowing.
“One area of attention is global US dollar funding markets, which are likely to remain a key pressure point during episodes of market stress. Banks' continued heavy reliance on short-term US dollar funding, paired with a high degree of market concentration and interconnectedness, underscores the importance of supervisory cooperation and effective backstops,” said BIS.