Banking body warns central banks against low rates
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Central banks could be putting their economies at risk by continuing with ultra-low interest rates, according to the Bank for International Settlements.
The BIS, a European central banking group, says that the low rates in the UK, US and the Eurozone may be falsely inflating equities and allowing financial institutions to extend credit too freely.
In its annual report the BIS says: “Policymakers will need to consider the distortions caused by prolonged conditions of monetary ease. After all, sustained low interest rates have been identified by many as an important factor that contributed to the crisis.”
The UK base rate has been at its all-time low of 0.5 per cent since March 2009, while the US Federal Reserve has held its rate at near zero for nearly two years. The European Central Bank has held its base rate at 1 per cent since May 2009.
The BIS says a decrease in real interest rates causes an increase in asset prices since it drives down the discount factor for future cash flows. It says this leads to a rise in the value of collateral, which may induce financial institutions to extend more credit and to increase their own leverage to purchase riskier assets.
It says: “The broad rise in asset prices and the reduction in risk spreads that took place in 2009 and the early months of 2010 is thus best seen as reflecting both the success of these policies and a new build-up of potentially overly risky portfolios.”
The report suggests that an increase in interest rates will force banks to clean up their balance sheets in an attempt to readjust to more expensive borrowing. BIS also says the low rate environment encourages governments to continue managing their high debts,
It says: “Keeping interest rates very low comes at a cost – a cost that is growing with time. Experience teaches us that prolonged periods of unusually low rates cloud assessments of financial risks, induce a search for yield and delay balance sheet adjustments.
“Because these side effects create risks for long-term financial and macroeconomic stability, they need to be taken into account in determining the timing and pace of normalisation of policy rates.”
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