The conundrum of stubbornly low inflation despite a pick-up in global growth and continued monetary stimulus is a “trillion-dollar” question, the umbrella body for the world’s leading central banks said on Sunday.
The Bank for International Settlements (BIS) said in its latest quarterly report that cheap borrowing rates and the rare simultaneous expansion of advanced and developing economies are driving financial markets higher, with signs of “exuberance” starting to re-emerge.
US corporate debt is much higher than before the financial crisis and a drop in the premiums investors demand for riskier lending has boosted sales of so-called covenant-lite bonds offering high yields.
The BIS said this raises a question over the potential for another crisis if there is a significant rise in interest rates.
The body has called for a gradual return to higher rates, although central banks are being tentative because of persisting low inflation.
“It feels like Waiting for Godot,” BIS monetary and economic department head Claudio Borio said, referring to a play in which the main characters wait for someone who never arrives.
However, the BIS says that no one has yet worked out why inflation has remained so subdued while economies have approached or surpassed estimates of full employment and central banks have provided unprecedented stimulus.
“This is the trillion-dollar question that will define the global economy’s path in the years ahead and determine, in all probability, the future of current policy frameworks,” Borio said. “Worryingly, no one really knows the answer.”
The report also contained a study that showed global debt could be under-reported by about US$13 trillion, because traditional accounting practices exclude foreign-exchange derivatives used to hedge international trade and foreign currency bonds.
Another said that central banks need to do more work on digital or cryptocurrencies, but that they could make it easier to implement sub-zero interest rates, while a third said the shift to more domestically issued and longer-dated bonds in emerging markets could make them more resilient to external shocks despite the increase in overall debt levels.
There has been a doubling in outstanding government debt of emerging market economies since 2007 to US$11.7 trillion at the end of last year. Government debt rose from 41 percent to 51 percent of GDP over the same period.
However, the main focus of the report was the lack of inflation, the heady rally in financial markets, their ability to shrug off geopolitical tensions and what the BIS called the “remarkable” low levels of market volatility.
“We do not fully understand the factors at work, but surely the unprecedented gradual pace of monetary policy normalization has played a role,” Borio said. “All this puts a premium on understanding the ‘missing inflation,’ because inflation is the lodestar for central banks.”
The BIS, as normal, used its report to flag potential areas of risk that might be developing.
Since the global financial crisis, global debt in relation to GDP has continued to rise. Deleveraging has not really occurred and where private debt levels have adjusted, at least to some extent, public debt has taken over.
“A defining question for the global economy is how vulnerable balance sheets may be to higher interest rates,” the BIS said.
Certain indicators do also point to vulnerabilities. Property development, a traditional bubble-blower, is helping to fuel booms parts of Asia. Meanwhile, debt-service ratios are only so low because interest rates have fallen so much.
“There is a certain circularity in all this that points to the risk of a debt trap,” the BIS said.
The protracted decline in interest rates to unusually low levels, regardless of the strength of the underlying economy, creates the conditions that complicate their subsequent return to more normal levels, it added.
“Against this backdrop, the increase in the percentage of firms unable to cover their interest payments with their earnings — so-called ‘zombie’ firms — does not bode well,” it said.
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