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(Kitco News) The Bank for International Settlements (BIS), a bank for central banks, is warning of further financial stress as central banks continue to hike rates to battle the growing risk of "inflationary psychology" settling in.
Despite an already aggressive hiking cycle, central banks must do more, with many countries still struggling to bring inflation under control, the BIS said in its Annual Economic Report 2023 released Sunday.
"The key policy challenge today remains fully taming inflation, and the last mile is typically the hardest," said BIS general manager Agustin Carstens. "The burden is falling on many shoulders, but the risks from not acting promptly will be greater in the long term."
The last inning of battling inflation and restoring price stability will be the hardest for central banks, according to the BIS report. But the more central banks hike, the higher the risk of financial stress and bank failures, the BIS report said.
An "inflationary psychology" could be set in, which is why there is "a material risk of further financial stress as the financial system adjusts to the end of low-for-long interest rates," the report pointed out.
The problem with inflation is that the labor market remains tight, and price growth within the service sector has proven hard to bring down.
"There is a material risk that an inflation psychology will take hold, where wage and price increases start to reinforce each other. Interest rates may need to stay higher for longer than the public and investors expect," the report said.
And central banks are raising rates amidst high debt levels, which could reveal more weaknesses within the financial system. If interest rates were to reach the levels of the mid-1990s, the debt service burden for developed economies would be the highest in history, the BIS pointed out.
"Bank closures in early 2023 were the most striking example of such risks materializing but far from the only one," the report stated. "Hidden leverage and liquidity mismatches in the non-bank financial sector are another vulnerability. If central banks must tighten more or for longer to achieve price stability, the risk of financial stress will grow."
The BIS called for prudential policies to help stabilize the economy and the financial system, including tighter budgets and long-term consolidation of spending.
"The global economy is at a critical juncture," Carstens noted. "The time to obsessively pursue short-term growth is past. Monetary policy must now restore price stability. Fiscal policy must consolidate."
The BIS estimated that around 15% of rate hike cycles lead to severe stress in the banking sector. "Very high debt levels, a remarkable global inflation surge, and the strong pandemic-era increase in house prices check all these boxes," the BIS said.
Markets are closely monitoring this week's three-day monetary policy forum hosted by the European Central Bank in Sintra, Portugal, featuring comments from Federal Reserve Chair Jerome Powell, ECB's President Christine Lagarde, Bank of England's Governor Andrew Bailey, and others.
Also, the Fed will publish the results of its annual banking industry stress test on Wednesday.
In the meantime, a global central banks' hawkish push is keeping gold prices under pressure after last week's selloff. August Comex gold futures last traded at $1,937.50, up 0.41% on the day.
