Central banks could be forced to backstop 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 for central banks, said the crisis that unfolded in UK gilt markets in September underlined the risk that monetary authorities could be forced to inject liquidity into financial markets at a time when they are trying to rein in price pressures through higher interest rates and are shrinking their balance sheets.
The BIS said in its quarterly review that other large defined benefit pension systems were less vulnerable to fire sales than those in the UK, but that similar risks had built up in many parts of the non-bank financial sector during a long period of low interest rates. Since the 2008 global financial crisis, central banks have kept borrowing costs at historic lows and pumped trillions of dollars into the financial system through quantitative easing programmes. That has led investors to seek riskier returns.
“When these risks materialise and the attendant economic costs are substantial, there will be pressure on central banks to provide a backstop,” the BIS said. “While justified, this can contrast with the monetary policy stance and encourage risk-taking in the longer run.”
With interest rates having risen rapidly across the world this year, and liquidity in the core US Treasury market “noticeably worse” than during the previous period of turmoil in March 2020, a sudden rush to deleverage could lead to market dysfunction, the BIS said.
The Bank of England has been acutely sensitive to the charge that its gilt-buying intervention could hinder its efforts to curb inflation and delay its plans to shrink its balance sheet by selling assets accumulated under QE. The US Federal Reserve has also started to sell off assets this year, while the European Central Bank is expected to begin debating what to do with its bond stockpile next week ahead of beginning a programme of sales in 2023.
Andrew Bailey, the BoE governor, told the Lords economic affairs committee last week that it had been “imperative” to end the operation promptly. The operation constituted a “serious moral hazard problem” — since parts of the market “would love to have the Bank of England permanently offering to buy gilts” — and “was running directly counter to the operation of monetary policy”.
“What we’ve seen in the UK is just one possible example of what might happen,” said Claudio Borio, head of the BIS’s monetary and economic department, who called it “unprecedented” for central banks to be tightening monetary policy to bring down inflation in a context of high debt and high property prices.
The UK episode underlined the urgency of tightening regulation of the non-bank financial sector, which had “grown in leaps and bounds” since the global financial crisis, and had hidden vulnerabilities that “may not stay in the non-bank sector,” said Borio.
The BIS pointed to increasingly volatile agency mortgage-based securities markets as another area that carried threats for financial stability because MBS played a crucial role in enabling credit to the US real estate sector and were also often viewed as near substitutes for US Treasuries.
During the 2008 crisis, and when markets came under strain early in the pandemic, the US Federal Reserve bought large volumes of MBS to help support the market at a time when smaller investors had stepped aside.
But small investors and leveraged funds, which tended to be “less forthcoming than banks in providing liquidity in times of stress”, had now become the main buyers of these assets, the BIS said, adding: “Monetary policy priorities may make it challenging for the Federal Reserve to backstop the MBS market, should the need arise.”
However, the BIS acknowledged that some of the worst strains in markets had eased in recent weeks as investors revised down their expectations of the ultimate extent of monetary tightening needed to control inflation, and as the dollar weakened and the energy outlook for Europe improved.
This had led to an improvement in bond market liquidity, which had earlier reached its lowest level since the global financial crisis for a group of advanced economies, the BIS said.