MNI INTERVIEW: Key Quotes From Interview With BIS Borio

--First part of two

By Christian Vits

     FRANKFURT (MNI) - Below are the key quotes form the recent Market News

interview with the Head of the Monetary and Economic Department at the Bank for

International Settlements, Claudio Borio:

     On challenges for central banks:

     The most immediate economic challenge is to help the economy sustain its

expansion coupled with lasting price stability. This is a tricky challenge, as

economies are still dealing with the legacy of the past crisis in the form of

continued very low interest rates, increased levels of indebtedness relative to

output and, in the background, declining productivity growth.

     The second challenge is of a longer-term nature and relates to frameworks:

whether and, if so, how to refine policy frameworks to ensure lasting price

stability alongside financial and macroeconomic stability.

     The third challenge is of a more political economy nature. It has to do

with the expectations gap that has developed between what central banks can

deliver and what people expect them to deliver.

     Meeting the first challenge cannot be done by monetary policy alone.

Monetary policy requires the support of prudential, fiscal and structural

policies, in what might be termed a macro-financial stability framework. It

would be a big mistake to believe otherwise. Central banks have been

overburdened for far too long. A better understanding of this condition would

also help address the expectations gap.

     On financial/business cycles:

     The key point about financial cycles is that they are considerably longer

than business cycles. The business cycle, as economists tend to conceive and

measure it, has an average duration of roughly eight to 10 years, while

financial cycles have been much longer since the '80s - something like 16 to 20

years.

     Why have financial cycles become larger and longer since the '80s? A number

of factors may have been at work.

     One has been financial liberalisation, which has given further play to

loosely anchored perceptions of value and risk. This helps generate financial

expansions followed by contractions, as balance sheets become overstretched.

     A second has been the globalisation of the real economy, which has provided

fertile ground for financial booms by raising growth expectations, while at the

same time generating disinflationary pressures. Indeed, the inflation process

has proved rather insensitive to domestic measures of slack for quite some time.

     All this has raised new challenges for monetary policy frameworks focused

on near-term inflation control, as these financial cycles have tended to occur

against the background of low and sometimes falling inflation. Under those

conditions, there is no reason for the central bank to tighten during the boom,

potentially accommodating the build-up of financial imbalances. And when the

boom then turns to bust, you end up having to address the host of tough problems

that we have seen post-crisis.

     On low inflation/globalisation:

     One can think of two types of effect of the globalisation of the real

economy on inflation. At cyclical frequencies, globalisation tends to increase

the relevance of global capacity constraints relative to domestic ones. At lower

frequencies, it can put persistent downward pressure on inflation, by reducing

the pricing power of labour and firms and thus making wage-price spirals less

likely. Technological innovation may have similar effects - think, for instance,

of how it has promoted global value chains, of the automation of jobs and of the

Amazon effect.

     What are the prospects for inflation? It is a tug-of-war between opposing

forces. In a synchronised global expansion, with many economies reaching their

capacity limits simultaneously, one could expect inflation pressures to

increase. On the other side, we have the more structural disinflationary forces

I just mentioned, coupled with the scarring effects of the crisis. The longer

the expansion continues, the more likely it is that the former will gain the

upper hand.

     And, let me add, were the world to turn more protectionist, as the recent

rhetoric suggests, there would be untoward implications for inflation too. In

the short run, this would tend to raise prices and costs. And if a broader

change in regime took place, giving labour and firms more pricing power and

undoing some of the beneficial effects of globalisation, this could provide a

more fertile ground for inflation.

     Trade wars can have no winners, only losers.

     On the Phillips curve:

     The relationship between inflation and domestic slack does exist, but it

has proved weaker than expected and somewhat unstable. The questions concern, in

particular, the strength of the relationship and the relative role of domestic

and global capacity constraints.

     Over time, one would expect the persistent disinflationary pressures linked

to the entry of low-cost producers into the world trading system - which may

obscure the standard Phillips curve relationship - to wane. This is because the

labour-cost differentials between the new entrants and the more advanced

economies tend to fade. But all the indications are that the impact of

technology could loom larger.

     On the side-effects of low interest rates for long:

     It is generally recognised that there are side effects if interest rates

stay unusually low for unusually long. They can delay balance sheet repair; hurt

banks' and other financial institutions' profits, and hence resilience; induce a

misallocation of resources; and encourage risk-taking in financial markets.

     Take a couple of examples. Very low interest rates reduce the opportunity

cost of keeping non-performing loans on banks' books, possibly slowing down

their resolution. Similarly, we have seen an increase in the incidence of firms

whose profits do not cover interest payments, dubbed Zombie firms, which may be

linked to lenders' greater tolerance in a low interest rate environment.

     Those costs need to be balanced against the well-known benefits, as low

rates boost economic activity and help bring inflation back to target. And,

indeed, economies are back on track. Of course, as economies improve, the

balance between the benefits and costs of persistent unusually low rates tends

to deteriorate.

     After such a long period of unusually low interest rates, coupled with

growing central bank balance sheets, normalising policy presents serious

challenges, not least as the global economy has seen a further increase in debt

levels in relation to incomes and output. It is a narrow path, complicated more

recently by the protectionist rhetoric that has been gaining ground. 

     What is clear is that normalising policy will not be without hiccups. For

instance, it would be unrealistic not to expect bouts of market volatility, as

confirmed by the recent wobbles in the US stock market. But as long as this

volatility stays in financial markets, there is no reason to be distracted from

the long-term course, which should be driven by macroeconomic developments.

--MNI Frankfurt Bureau; +49 69 97782671; email: christian.vits@marketnews.com

[TOPICS: M$E$$$,M$X$$$,MC$$$$,MI$$$$,M$$EC$]