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Central banks should not cut interest rates too quickly because of the risk of a new inflation flare-up, the Bank for International Settlements has warned. Policymakers around the world are considering how quickly to ease monetary policy.
The Basel-based central bank body said in its annual report that the global economy appeared poised for a “soft landing” as inflation eased and growth remained resilient.
But it urged rate setters to “set the bar high” on policy easing, warning of the risk of a rebound in areas such as services prices and wage growth, and of the need to leave some room to cut borrowing costs in the case of a sudden downturn.
It also warned that the financial system remains vulnerable, especially to high government debt and falling commercial property prices.
“A premature easing could reignite inflationary pressures and force a costly policy reversal – all the more costly as credibility would be undermined,” the BIS said.
The U.S. Federal Reserve and European Central Bank were widely criticized for being slow to respond in 2021 and 2022 as supply chain disruptions from the pandemic and a surge in energy prices led to the biggest wave of inflation in a generation.
BIS Chief Executive Agustín Carstens praised the “strong tightening” that eventually followed, arguing that it strengthened the credibility of central banks and prevented a shift to a “high inflation regime”.
But the BIS warned top officials to remain wary of a return of inflationary pressures, even as some central banks had already begun easing policy. The ECB began cutting interest rates in June, while the Fed is expected to cut borrowing costs as early as September.
Although inflation has been steadily declining, it is still above the targets of central banks in many parts of the world, including the US and the eurozone. However, in parts of East Asia, including China, inflation is more moderate.
Carstens compared a central banker who fights inflation with high interest rates to a doctor prescribing antibiotics to a patient with an infection, telling reporters: “You have to do the whole treatment, otherwise inflation can come back.”
The former head of Mexico’s central bank identified a number of “key sticking points” that could thwart the soft landing, including weak public finances, low productivity growth and “persistent inflationary forces.”
Crucially, the BIS found that the price of services relative to core goods in many jurisdictions remained well below pre-pandemic trends. Similarly, real wages, relative to the cost of goods and services, also lost ground during the rise in inflation.
“A too rapid reversal of either of these relative prices – or both – could create material inflationary pressures,” Carstens said.
For example, regaining the purchasing power lost by workers as a result of rising inflation could amount to 0.75 percentage points of inflation in the major euro area economies in 2025, and 1.5 percentage points in 2026, the BIS estimates.
A faster wage recovery could increase inflation by 1.5 percentage points in 2025 and by more than 2.5 percentage points in 2026.
Fiscal policy must also be kept strict so that persistent inflationary pressures do not worsen, the BIS said.
The BIS did find pockets of downward pressure on inflation. Falling export prices and weaker Chinese domestic demand reduced the annual rate of import price increases in other major economies by about 5 percentage points in 2023, the BIS said.
The BIS identified rising government debt as the biggest threat to monetary and financial stability, saying there was a risk that markets could quickly turn against governments perceived to have unsustainable levels of debt.
“We know that things look sustainable until suddenly they don’t – that’s how markets work,” said Claudio Borio, head of the body’s monetary and economics department.
The BIS said that financial stress has historically occurred two to three years after the start of an interest rate rise cycle, meaning it could still happen within the next year.
It labeled commercial real estate as a high-risk area as it “faced both cyclical and structural headwinds”. A sharp correction in property values could reduce lending by 12 percentage points and GDP by 4 percentage points in many advanced economies, as in the 1990s, it added.
Commercial property owners could keep valuations artificially high, the report said, warning of the risk of an “extend and pretend” strategy as banks continue to extend credit to prevent losses from crystallizing in the hope that interest rates will fall and allow them to recover.