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Is the BIS hitting the alarm too soon?

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COMMENTS

4 July 2011 13:27

The Annual report of the Bank for International Settlements (the central bankers' 'club' in Basel) is pressing the alarm button on both monetary and fiscal policy, not just for specific countries, but for the world as a whole.

They have a point on fiscal policy. The Global Financial Crisis did a lot of damage to the fiscal position of many countries (Ireland, for example, was in pretty good fiscal shape until the bankrupt banking system was bailed out by the government).

It was not so much the direct cost of the GFC, but the sharp recession and slow recovery that has put many budgets into deep deficit. The political task of fixing this seems daunting. Greece may be the most dramatic, but the blockage in the US seems as intractable.

Whatever the case for tighter fiscal policy, the BIS seems to have gone out on a limb on monetary policy: 'Highly accommodative monetary policies are fast becoming a threat to price stability.' The BIS notes that interest rates are historically very low and that headline inflation is high.

True enough, but interest rates are low because GDP in the Euro area, the US and Japan has barely recovered its pre-GFC levels and in the UK is still 5% lower. Inflation is above target because world commodity prices are rising.

This reflects sluggish supply responses and strong demand from China, India, Brazil and a host of other emerging countries, which are not only growing quickly, but are now large enough to have a significant effect on global demand.

But tightening monetary policy in the UK, for example, isn't going to alter world commodity prices. UK demand is slack, credit is contracting, unemployment is high, wages are flat and fiscal austerity dampens prospects. The European Central Bank has promised another interest rate increase this month, but the BIS is urging more.

This, at a stretch, might be bearable for Germany, but the peripheral crisis countries (Greece, Ireland and Portugal) get the same tightening, as does Spain, with 20% unemployment. In the US, headline inflation is high but excluding petrol, core inflation is running at a little over 1%. Unemployment is 9%.

The BIS seems to be straining to make the case for monetary tightening. They see little spare capacity as measured by the output gap (the gap between actual and potential output). But this may be a misreading: they measure potential output using a moving average of actual output, so this measure of the gap disappears asymptotically as the recovery drags on.

They worry about wage growth, but they have to go to the fast-growing emerging countries to find any evidence of this. The same goes for credit and asset prices. Sure, you might make a case for tighter policies in China, India and Brazil but this is different from saying 'policy rates should rise globally'.

What should individual countries do in the face of a world-wide rise in commodity prices? When a country is hit by a supply-side price shock, the accepted policy response is to allow this price shock to change relative prices, and set monetary policy to discourage the shock from being passed on to domestic price increases (for example, to wages). This is true for the world as a whole. The BIS seems to have a different analytical framework, which worries that low interest rates are giving the wrong signals for balance sheet adjustment.

Of course there are always dangers that things will go off track again, and the current conjuncture seems to have more than the usual share of economic hazards and potential disasters. Predicting disasters is part of the BIS job, and some BIS economists did better than most in foretelling the GFC (see, for example, Claudio Borio).

The current BIS economists may think that, with so many pitfalls around, some earnest hand-wringing will put them in a position, once again, to say 'I warned you'. The issue, however, is not just whether things might go wrong, but whether immediate action to tighten the settings of fiscal and monetary policy is going to make things better or worse.

Photo by Flickr user Angelina :).

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