Central banks' struggle continues despite easing inflation: BIS

27 Jun '23

2 min read

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Insights

The BIS warned that despite a recent easing of inflation, central banks face challenges in restoring price stability.
The BIS report suggested that interest rates may need to remain high for longer, posing risks for high debt and inflated asset prices.
To alleviate this, fiscal tightening and long-term spending consolidation by governments is advised.

Inflation has started to subside from multi-decade highs almost everywhere, but the work of central banks is far from done, as per the Bank for International Settlements (BIS). Despite the most intensive monetary policy tightening in recent memory, the last leg of the journey to restore price stability will be the hardest.

The gains made so far in the fight against inflation owe much to supply chains easing and commodity prices falling. But labour markets are still tight and price growth in services has proved harder to tame. There is a material risk that an inflation psychology will take hold, where wage and price increases start to reinforce each other. Interest rates may need to stay higher for longer than the public and investors expect, according to the BIS’ Annual Economic Report 2023.

The report analysed the risks posed by the unique mix of high inflation and financial stability risks. Central banks are tightening against a backdrop of high debt and asset prices, a legacy of risk-taking in financial markets when interest rates were low for long.

Bank closures in early 2023 were the most striking example of such risks materialising but far from the only one. Hidden leverage and liquidity mismatches in the non-bank financial sector are another vulnerability. If central banks must tighten more or for longer to achieve price stability, the risk of financial stress will grow, added the report.

Fiscal and prudential policies can do their part to help stabilise the economy and the financial system. Governments should tighten their budgets, while targeting support on the most vulnerable, and embarking on a long-term consolidation of their spending. This would help curb inflation and keep financial stability risks in check by reducing the need for central banks to keep rates higher for longer.

Regulatory and supervisory authorities can deploy the full range of tools at their disposal to strengthen the financial system, giving central banks more room to manoeuvre.

In the longer term, policy adjustments and institutional safeguards are needed to ensure that monetary and fiscal policies remain firmly within the region of stability.

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