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Central banks should avoid cutting interest rates too soon due to the risk of a fresh flare-up of inflation, the Bank for International Settlements warned, as policymakers around the world consider how quickly to ease monetary policy.
The Basel-based central bank’s umbrella body said in its annual report that the global economy appeared poised for a “soft landing” as inflation cooled and growth remained resilient.
But she urged ratemakers to set a “high bar for policy easing”, warning of the risk of a recovery in areas such as service prices and wage growth, as well as the need to keep some room to lower borrowing costs in the event of a sharp downturn.
It also warned that the financial system remains vulnerable, particularly to high levels of public debt and falling commercial property prices.
“Premature easing could reignite inflationary pressures and force a costly policy shift – all the more costly as credibility would be eroded,” the BIS said.
The U.S. Federal Reserve and the European Central Bank have been widely criticized for their slow response in 2021 and 2022, when supply chain disruptions from the pandemic and a spike in energy prices helped trigger the biggest rise in inflation in a generation.
BIS Director General AgustÃn Carstens praised the “forceful tightening” that eventually followed, arguing that it strengthened the credibility of central banks and prevented a shift to a “regime of high inflation”.
However, the BIS warned top officials to remain vigilant against a return to inflationary pressures, even as some central banks have already begun to ease policy. The ECB began cutting rates in June, while the Fed is expected to cut borrowing costs as early as September.
While inflation has been steadily falling, it remains above central bank targets in most of the world, including the US and the eurozone, although it is more subdued in parts of East Asia, including China.
Comparing a central banker fighting inflation with high interest rates to a doctor giving antibiotics to a patient with an infection, Carstens told reporters: “You have to do the whole treatment or inflation could come back.”
The former head of Mexico’s central bank cited a number of “important pressure points” that could derail a soft landing, including weak public finances, low productivity growth and “persistent inflationary forces.”
Critically, the BIS found that the price of services relative to the price of basic goods remained well below pre-pandemic trends in many jurisdictions. Similarly, real wages lost ground relative to the cost of goods and services during the upswing in inflation.
“Too rapid a reversal of one — or both — of these relative prices could create material inflationary pressures,” Carstens said.
For example, compensating for workers’ purchasing power lost to inflationary increases could add up to 0.75 percentage points to inflation in major eurozone economies in 2025 and 1.5 percentage points in 2026, the BIS estimates.
A faster catch-up in wages could add 1.5 percentage points to inflation in 2025 and more than 2.5 percentage points in 2026.
Fiscal policy should also be tight so as not to exacerbate ongoing inflationary pressures, the BIS added.
Indeed, the BIS has found places where inflationary pressures are easing. Falling export prices and weaker Chinese domestic demand reduced the annual growth rate of import prices in other major economies by about 5 percentage points in 2023.
The BIS identified rising public debt as the biggest threat to monetary and financial stability and said there was a risk that markets could quickly turn to governments believed to have unsustainable debt levels.
“We know that things look sustainable when they suddenly stop working – that’s how markets work,” said Claudio Borio, the body’s head of monetary and economic affairs.
The BIS said financial stress has historically occurred two to three years after the start of a rate hike cycle, meaning it could still occur over the next year.
It identified commercial real estate as a high-risk area as it “faced both cyclical and structural headwinds.” A sharp correction in property values ​​could squeeze credit by 12 percentage points and reduce GDP by 4 percentage points in many advanced economies, as it did in the 1990s, he added.
Commercial property owners could keep valuations artificially high, he said, warning of the risk of a “extend and fake” strategy as banks continue to lend to avoid crystallizing losses in the hope that interest rates will fall and allow them to recover.