The Bank of International Settlements meets to discuss low inflation and how to best deal with the problem has some of the best financial minds in the world scratching their heads.
The Bank for International Settlements (BIS) described it as a trillion dollar” question in its latest report, stating cheap borrowing rates and simultaneous expansion of advanced and developing economies are driving financial markets higher, with signs of “exuberance” starting appear.
U.S. 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, though central banks are being tentative because of persisting low inflation.
“It feels like ‘Waiting for Godot’,” said Claudio Borio, the head of the monetary and economic department of the BIS, referring to a play in which the main characters wait for someone who never arrives.
But the BIS says 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 primary focus of the report was the lack of inflation, the strong rally in financial markets, their resistance to geopolitical tensions and what the BIS described as 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.”
Other key points:
- Global debt in relation to GDP has continued to rise. “A defining question for the global economy is how vulnerable balance sheets may be to higher interest rates.”
- Property development is helping to fuel booms in parts of Asia. Debt-service ratios, meanwhile, 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.”
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