Market turmoil threatens to undermine inflation-fighting efforts, says BIS

Central banks could be forced to prop up crucial parts of the financial system that are vulnerable to higher interest rates, undermining their attempts to fight inflation, the Bank for International Settlements warned on Monday.

The BIS, dubbed the bank of central banks, said the crisis that unfolded in Britain’s gilt markets in September underscored the risk that monetary authorities would be forced to inject liquidity into financial markets at some point. where they attempt to contain price pressures by raising interest rates and shrinking their balance sheets.

The BIS said in its quarterly review that other large defined-benefit pension systems were less vulnerable to sell-offs than those in the UK, but similar risks had built up in many parts of the non-banking financial sector in the UK. during a long period of low interest rates. rates. Since the global financial crisis of 2008, central banks have kept borrowing costs at historic lows and injected billions of dollars into the financial system through quantitative easing programs. This has led investors to seek riskier returns.

“When these risks materialize and the resulting economic costs are substantial, pressure will be put on central banks to provide a backstop,” the BIS said. “While warranted, this may contrast with the stance of monetary policy and encourage longer-term risk-taking.”

With interest rates rising rapidly around the world this year and liquidity in the US Treasury central market “significantly worse” than during the previous turbulent period in March 2020, a sudden push towards deleveraging could cause the US Treasury to malfunction. market, the BIS said.

The Bank of England has been extremely sensitive to the accusation that its gilt-buying intervention could hamper its efforts to rein in inflation and delay its plans to shrink its balance sheet by selling assets accumulated under QE. . The US Federal Reserve has also started selling assets this year, while the European Central Bank is expected to start debating what to do with its bond stock next week before launching a sales program in 2023.

Andrew Bailey, the BoE governor, told the Lords Economic Affairs Committee last week that it was “imperative” to end the deal quickly. The deal was a “serious moral hazard problem” – since some parts of the market “would like the Bank of England to continually offer to buy gilts” – and “directly ran counter to the workings of policy.” monetary”.

“What we’ve seen in the UK is just one possible example of what could happen,” said Claudio Borio, head of the BIS’s monetary and economic department, who called it “unprecedented” that the central banks are tightening their monetary policy to bring down inflation in a context of high debt and high house prices.

The UK episode underscored the urgency of tighter regulation of the non-banking financial sector, which had “progressed by leaps and bounds” since the global financial crisis, and presented hidden vulnerabilities that “may not remain in the non-banking sector,” Borio said.

The BIS pointed to the increasingly volatile agency mortgage-backed securities markets as another area that threatened financial stability, as MBS played a crucial role in extending credit to the US real estate sector and were also often considered as close substitutes for US Treasuries.

During the 2008 crisis, and when markets were strained at the start of the pandemic, the US Federal Reserve bought large volumes of MBS to help prop up the market at a time when retail investors had retreated. .

But retail investors and leveraged funds, which tended to be “less willing than banks to provide liquidity in times of crisis”, had now become the main buyers of such assets, the BIS said, adding: “Monetary policy priorities may make it difficult for the Federal Reserve to support the MBS market, should the need arise.

However, the BIS acknowledged that some of the worst market stress had eased in recent weeks as investors scaled back their expectations of the ultimate extent of monetary tightening needed to control inflation, and the dollar was weakening and the energy outlook for Europe was improving.

This led to an improvement in bond market liquidity, which had previously hit its lowest level since the global financial crisis for a group of advanced economies, the BIS said.