BIS Official: Central Banks Must Curb Inflation at the Expense of the Economy

Inflation tests the limits of stability and central banks must raise interest rates and abandon the stimulus policy from the crisis period, even at the cost of slowing down the economy, believes an official from the Bank for International Settlements (BIS).

The years-long struggle against economic crises has created conditions that test the limits of stability in the international financial sector, stated BIS General Manager Agustín Carstens in a speech in Washington.

Fiscal and monetary policy supported the economy during the pandemic crisis, Carstens recalls, explaining the causes of inflation which, according to him, began to accelerate during the pandemic crisis, driven by disruptions in supply chains.

After the lifting of pandemic restrictions, price growth accelerated due to a strong recovery in demand, and then also due to rising energy prices influenced by the war in Ukraine, he notes.

Central banks began raising interest rates last year, and to avoid a long-term ‘high inflation regime’, they may need to remain higher and longer than previously thought, even at the cost of slowing down economies, emphasized Carstens.

The role of central banks has been complicated by debts accumulated during the global financial crisis and the COVID-19 pandemic, he notes, and some are already facing political pressure to hit the brakes in the cycle of raising interest rates to avoid increasing debt servicing costs.

At the same time, they are also facing significant losses, at least on paper, due to billions of dollars or euros worth of bonds they purchased to support liquidity and the economy during the crisis, which means that governments are no longer receiving a share of the profits that these purchases once brought them.

These risks are concrete, tangible, said Carstens.

Financial instability is a major challenge for central banks, he emphasizes, warning that since the 1970s, in nearly one-fifth of cases, about three years after the start of a coordinated global cycle of interest rate increases, stress in the banking system followed.

Due to a significant acceleration of inflation and a higher level of private sector debt, the chances of such stress are even greater, Carstens warned.

For the first time since World War II, inflation has accelerated during a period of high debt levels, he noted.

This also means that central banks should change their policy in the future and refrain from aggressive interest rate cuts or stimulus when inflation falls below target levels, he believes.

This, according to him, would limit the negative side effects of ultra-low interest rates, primarily the accumulation of financial weaknesses in the banking sector that we have been witnessing recently, he concluded.