Hawkish BIS warns on dangers of ultra-low rates

Bank for International Settlements says degree of slack likely to be smaller than suggested by output gap models

The Bank for International Settlements (BIS) on Monday cautioned central banks on leaving rates too low for too long, saying that ultra loose policy was likely to stoke inflation sooner than many expect.

The BIS said the degree of slack in economies was likely to be far smaller than suggested by conventional measures of the output gap - measures which some policymakers at the Bank of England and the Federal Reserve have cited as justification for keeping rates at record lows for an extended period. "The build-up of imbalances in the run-up to the crisis suggests that potential output growth during that period may not have been as high as was believed at the time," the BIS said. "Moreover, the financial disruptions caused by the crisis and the lost skills of the long-term unemployed could reduce potential output for some time to come."

The comments, which come in the BIS's influential Annual Report, are likely to please the more hawkish members of the Federal Open Market Committee - such as Thomas Hoenig, the president of the Kansas City Fed, and Charles Plosser, the president of the Philadelphia Fed - who have both argued that there was less slack in the economy than output gap estimates suggest. The Bank has cited the output gap in many of its recent Inflation Reports and minutes of its rate-setting meetings as evidence of the downward pressures on inflation, set to emerge towards the back end of 2010. However, Andrew Sentance, the Monetary Policy Committee member who earlier this month backed a rate rise, said the fact that inflation had proven resilient in the aftermath of the recession cast doubt on the future dampening impact of spare capacity on price pressures.

The BIS further warned on the dangers that central banks could be set to repeat the mistakes of the recent past. "A prolonged period of exceptionally low real interest rates alters investment decisions, postpones the recognition of losses, increases risk taking in the ensuing search for yield, and encourages high levels of borrowing," the BIS said. "Our recent experience with exactly those consequences a mere five years' ago should make us extremely wary this time around."

The BIS acknowledged that the retrenchment of fiscal support seen in Britain and Europe would have consequences on inflation and enable rates to stay lower for longer. The report warned, however, that central banks may face political pressure to tolerate rapid price growth as governments attempt to inflate their debts away. The BIS pointed out that although inflation expectations have not yet shown any sign of slipping their anchor, "a failure by governments to make headway in restoring fiscal sustainability increases the risk that inflation expectations may abruptly and unexpectedly change."

The BIS also called on central banks to lengthen their policy horizon "to naturally allow monetary authorities to consider financial stability more fully." In so doing, they would, the BIS said, "promote price stability more effectively over the longer term."