BASEL, Switzerland (MNI) – The looseness of monetary policy in many
economies of the world is rapidly turning into an inflationary risk, the
Bank for International Settlements said in its latest Annual Report,
released Sunday.

Despite financial sector frailties, central banks may need to
tighten faster than in the past, because there is a danger of inflation
expectations becoming unanchored, BIS said.

Although “advanced economies have been moving towards a
self-sustaining recovery, it would be a mistake for policymakers to
relax” since the crisis has left various “legacies and lessons” that
need addressing, the institution said.

These include high debt levels that continue to weigh on household
spending and on companies in many major economies; re-emerging global
financial imbalances; and “highly accommodative monetary policies” that
“are fast becoming a threat to price stability.”

Narrowing output gaps and higher commodity prices have already
driven up inflation risks overall, the report said.

“The spread of inflation dangers from major emerging market
economies to the advanced economies bolsters the conclusion that policy
rates should rise globally,” the BIS said.

“The great danger is that long-term inflation expectations will
start to climb, and current price developments and policy stances are
sending us in the wrong direction,” it argued.

Re-anchoring inflation expectations would require “a costly,
protracted effort,” the BIS reminded.

“As spare capacity dwindles, food and energy price increases are
more likely to have second-round effects on inflation,” it warned. “And
the risks to long-term inflation expectations are intensified by
continued unconventional monetary policy actions, outsized central bank
balance sheets in the core advanced economies and a perceived temptation
to inflate away the real value of ballooning government debt.”

Some countries that face the need to raise borrowing costs are also
confronting “vulnerabilities linked to still-distorted balance sheets
and lingering financial sector fragility,” but nevertheless, “once
central banks start lifting rates, they may need to do so more quickly
than in past tightening episodes,” the BIS wrote.

The challenges facing monetary policy “are intensifying” and the
period of accommodation is “already prolonged,” according to the BIS.
Very low interest rates in major advanced economies are slowing the pace
at which households and financial institutions adjust their balance
sheets. This in turn “is magnifying the risk that the distortions that
arose ahead of the crisis will return.”

As central banks seek to cope with the need to exit from measures
taken during the crisis, their own balance sheets also pose risks, the
BIS said. “Failure to manage those risks could weaken their hard-won
credibility in delivering low inflation, as could a late move to tighten
policy through conventional channels.”

The pre-crisis housing and financial sector boom concealed
long-term fiscal weakness “that, if left unchecked, could trigger the
next crisis,” the BIS warned.

In language that was relatively blunt for this cautious
institution, the BIS continued: “We should make no mistake here: the
market turbulence surrounding the fiscal crises in Greece, Ireland and
Portugal would pale beside the devastation that would follow a loss of
investor confidence in the sovereign debt of a major economy.”

The lessons to be drawn from the crisis should be heeded in
emerging economies as well, the bank argued, with an eye towards those
where property prices and consumption are being driven by rising debt.

These countries “are running the risk of building up the imbalances
that now plague the advanced economies,” the report warned. Moreover,
inflationary pressures are on the rise in these [emerging] economies and
the credit and property price booms pose risks that central banks must
consider.

Current account imbalances have not disappeared and could lead to
disorderly developments on foreign exchange markets or to protectionism,
the bank said. Gross financial flows exhibit much larger imbalances yet,
and if cross-border capital flows reversed suddenly, that could harm
financial sectors and the real economy, the BIS said.

–Frankfurt bureau tel.: +49-69-720142. Email: dbarwick@marketnews.com

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