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Aggressive monetary policy tightening might not be over, says BIS

Kitco News

(Kitco News) With U.S. markets worried about a more aggressive Federal Reserve due to stubborn inflation, the Bank for International Settlements warned that markets should not rule out a global synchronized reversion to higher-than-expected rate levels.

"Central banks have been very clear about the priority of getting the job done and of being cautious about declaring victory too early," said Claudio Borio, head of the monetary and economic department at the BIS. "[This] cautious attitude is the appropriate one."

To ensure that high inflation is brought under control, central banks will remain hawkish for longer than expected, the BIS said in its latest quarterly report.

It is important for central banks to avoid repeating the mistakes of the 1970s by not declaring victory too early, Borio told journalists.

"What you don't want to do at all costs is to repeat the stop-go policies of the 1970s when you are reversing (rates), and you then realize that the job has not been done," Borio said. "Then you have to go back and forth."

In the last few weeks, markets have fallen as investors re-price rate hike expectations. At the start of the year, markets were getting ready for rate cuts to kick in at the end of 2023. This was based on the idea that the Fed has done enough with its four percentage points tightening cycle.

However, investors were greeted by solid economic macro data from January, showing a robust economy, strong employment, and still problematically high inflation. This has triggered new expectations of the Fed raising rates higher and keeping them elevated for longer.

"The recent narrowing of the gap between central banks and markets is welcome," Borio said. "But not all has changed. Some of the general features of the financial landscape of the past three months are still very much with us."

Yet, even after the recent market selloff, the BIS noted that the pricing of financial assets still points to a "firm expectation that rate hikes would stop before the end of this year and that policy rates would decline materially in 2024.” But this might not be the case considering the "sharp contrast" of communication from central banks, with "no indication that easing was on the horizon."

Inflation is a problem since it is not coming down fast enough. And in some instances, it is accelerating.

The latest update of the Fed's preferred inflation measure — the annual core PCE price index — showed an acceleration in January, coming in at 4.7% versus the expected 4.3%. In the eurozone, core annual inflation, which strips out volatile food and energy prices, reached a new record high of 5.3% in January.

"[It is] much easier to get inflation from 8% to 4% when the work is done by [falling] commodities prices, than it is to get it from 4% to 2%, which is the part that central banks will have to do," Borio said.

The lesson from the 1970s is that inflation could show signs of deceleration but then reverse course, Hyun Song Shin, the BIS's head of research, told reporters.

"The reason central banks have been emphasizing [the importance of] going the last mile on bringing inflation down is that, if you are not fully back to target and relax too early, you will undo all the work you have done before," he said.

Another complication in the inflation narrative is that changes in monetary policy are now less impactful on consumer demand, making it harder for central banks to bring down price pressures, he added.

The BIS' quarterly report also released additional research on how a more restrictive monetary policy weighs on financial system stress and debt levels. The report also examined the relationship between higher commodity prices and a stronger U.S. dollar on the risk of stagflation.

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