When the bank of central banks warns about financial stability, you have to take notice — even if the warning comes in the Bank for International Settlements usually dry, academic style.
The BIS recently published a paper about the effect of prolonged interest rates on financial stability, and it makes worrying reading. (However, as most people are on holidays in August, unless they are reading it on the beach it will largely go unnoticed).
More worrying, however, is the fact that illustrious BIS members focus on the wrong, or rather incomplete, measure of inflation when considering future monetary policy steps.
Let’s first look at the financial stability issues caused by “low-for-long” interest rates. The BIS paper identifies four dangers: banks could come under strain because of low profitability, restraint on risky loans might wear off, some insurers and pension funds could go bankrupt because of the low rates, and finally, in case of an abrupt “snap-back” in interest rates, banks would see some of their loans lose value.
The paper mentions that banks, in order to mitigate the effect of lower interest rates over the past decade since the financial crisis, have shifted their focus on longer maturity assets and on the interest rate-sensitive real estate sector.
“In a number of countries, real estate loans have picked up as a source of higher return, especially for smaller regional banks. Banks also have sought higher returns by switching increasingly from issuing variable to issuing fixed rate mortgages,” the paper says.
And, it adds, “a few of the representatives highlighted concerns that some of the steps banks were taking to boost return in the low interest rate environment would make them vulnerable should interest rates snap back and assets prices adjust accordingly.”
However, in speeches accompanying the release of the paper, BIS experts focus on consumer price inflation to discuss monetary policy, almost ignoring asset price inflation.
Princeton professor Alan Stuart Blinder mentions that the 2% target for consumer price inflation was chosen by central banks in the 1990s, when the problem was getting inflation down, not up.
“Central banks have since devoted much educational effort, and staked a great deal of their credibility, on the 2% inflation target – and especially on its role as the nominal anchor for inflation expectations,” he says.
As I have argued numerous times, focusing on consumer price inflation misses the fact that central banks’ extraordinarily easy monetary policies did manage to push prices up – only, they did so for asset prices.
For example, looking at the housing market in various countries since the crisis, we can see that central banks’ intervention arrested house price falls in some countries, or pushed them higher in others.
In the chart below, showing house prices’ evolution since the crisis, it is clear that the European Central Bank’s money printing halted the fall in Spanish property prices, while pushing up home prices in Germany.
House prices also took off in Britain and Sweden — two countries that had “benefited” from easy monetary policy of their own central banks to such an extent, that warnings of bubbles forming reverberated long before the ECB started its massive asset purchases.
For Sweden, house prices have been rising almost without pause since the mid-1990s, to the point where now it looks like the only way the country can avoid a crisis is to ensure property prices keep increasing.
To some extent, the same is true for the UK, where Brexit jitters are beginning to show in the property market, threatening a reversal of the steep price increases.
Central banks are now scrambling for solutions. The BIS does not say this — or not directly, anyway — but the reason why the Bank of England, the Federal Reserve and the ECB are now all tightening monetary policy is the fact that in the next crisis, they will be caught short of ammunition.
But it is already too late. The house price increases, and the fact that they have ignored them for so long, have pushed the central banks with their backs against the wall. They will not be able to raise interest rates high enough or fast enough to deal with the next crisis.
When central bankers long for high consumer price inflation, they should be careful what they wish for. It may come true, but not in the way they hope.