If you know anything about the history of the BIS, you know that the bank’s latest annual report is glaringly ironic and somewhat hypocritical. The “bank for central banks” as the highly profitable institution is known, has for decades served as a secretive club for the world’s most influential central bankers. The lavish governors’ weekends hosted by the bank in Basel allow the world’s most powerful monetary policy mavens to discuss the most important issues facing the global financial system in complete privacy with no fear that anything will leak to the public or to the press.

In other words, the BIS serves to encourage and perpetuate the power and prestige of the world’s central bankers and provides a top secret forum for the monetary policy cabal to meet and commiserate safe at all times from the prying eyes of those to whom the bankers should by all rights be accountable.

In this context it’s somewhat absurd that the bank’s annual report — which, as a reminder, is required reading in treasury departments and monetary policy circles around the globe — contains a scathing critique of the very same policies which were no doubt devised, tweaked, and honed over dinner and fine wine in Basel. Nevertheless, the BIS’ latest tome is replete with criticism for the idea that the very people who make up the bank’s Board of Governors are indeed omnipotent.

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Excerpted from the BIS Annual Report

Policies have been unable to constrain the build-up and collapse of damaging financial booms, ie the global economy exhibits “excess financial elasticity” – think of an elastic band that can be stretched out further and further until, eventually, it snaps back more painfully.

The interaction of monetary regimes has spread the easing bias from the core economies to the rest of the world. This happens directly, because key international currencies – above all, the US dollar – are extensively used outside the issuing country’s borders. Thus, the core countries’ monetary policies directly influence financial conditions elsewhere. More importantly, an indirect effect works through the aversion of policymakers to unwelcome exchange rate appreciation. As a result, policy rates are kept lower and, if countries resort to foreign exchange intervention, yields are further compressed once the proceeds are invested in reserve currency assets.

All this raises the fundamental question that lies at the heart of the current policy debate: Why are market interest rates so low? And are they “equilibrium (or natural) rates”, ie are they where they should be? How are the market and equilibrium rates determined?

Inflation need not reliably signal that rates are at their “equilibrium” level. Rather, the key signal may be the build-up of financial imbalances. After all, pre-crisis, inflation was stable and traditional estimates of potential output proved, in retrospect, far too optimistic. If one acknowledges that low interest rates contributed to the financial boom whose collapse caused the crisis, and that, as the evidence indicates, both the boom and the subsequent crisis caused long-lasting damage to output, employment and productivity growth, it is hard to argue that rates were at their equilibrium level. This also means that interest rates are low today, at least in part, because they were too low in the past. Low rates beget still lower rates. In this sense, low rates are self-validating. Given signs of the build-up of financial imbalances in several parts of the world, there is a troubling element of déjà vu in all this.

Submitted by Tyler Derden
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