Financial system stress
Against this global backdrop, the resilience of the financial system will be tested.
Here, while deeply interconnected, it is useful to make a distinction between banks
and non-bank financial intermediaries (NBFIs).
Thanks to the wide-ranging post-GFC financial reforms, the banking sector is
now in a much stronger financial position. Above all, banks are much better
capitalised. This is what allowed prudential authorities to temporarily relax the
regulatory and supervisory constraints in the early stages of the Covid crisis, thereby
supporting economic activity.
But there is no room for complacency. For one, although banks’ direct exposures
to developments in Russia are comparatively small and manageable, indirect
exposures are more opaque. More importantly, macroeconomic prospects are a
major source of risk. Stylised simulations suggest that credit losses could be material.
Based on past relationships, along the market-implied interest rate path, bank credit
losses would be broadly in line with historical averages across AEs. But they would
be substantially higher in the scenario in which interest rates rise more steeply.
Vulnerabilities in the NBFI sector are more significant.
Not only do they matter
for banks, as they represent potentially large and opaque exposures. The losses
from the failure of a leveraged fund (Archegos) in 2021 are a case in point. These
also matter in and of themselves. This was underscored by the financial market
turmoil in March 2020. At the time, an abrupt “dash for cash” prompted massive
central bank intervention to stabilise markets. Structural vulnerabilities in the form
of hidden leverage and liquidity mismatches loom large in the asset management
sector. Hence the urgent need to redouble regulatory efforts in this area.
Policy challenges
Just as the policymakers were breathing a sigh of relief with the end of the
pandemic in sight, the flare-up of inflation and the Russia-Ukraine conflict have
raised new and daunting challenges. It is useful to distinguish the near-term from
the longer-term ones, although the dividing line between the two is quite fuzzy.
Near-term challenges
The overriding near-term challenge is to prevent the global economy from shifting
from a low- to a high-inflation regime. In doing so, policymakers will need to limit
the costs to the economy as far as possible and to safeguard financial stability.
Some pain, however, will be inevitable. As historical experience has shown time and
again, the long-term costs of allowing inflation to become entrenched far outweigh
the short-term ones of bringing it under control.
xiv BIS Annual Economic Report 2022
This is not just an economic challenge about policy calibration; it is also,
importantly, a political economy one.
Ever since the GFC, and even more so
following the Covid crisis, both monetary and fiscal policies have worked to boost
economic activity. With inflation languishing stubbornly below targets, there was
no obvious trade-off between easy policy and inflation. Indeed, fiscal policy was
invoked more than once to relieve some of the burden placed on monetary policy.
To be sure, trade-offs did not magically vanish. The exceptionally low interest rates
that persisted for so long did contribute to the gradual build-up of financial
vulnerabilities. But now trade-offs have come into view much more starkly.
Take fiscal policy first. The economic slowdown will further widen public sector
deficits. While this will cushion the blow to economic activity, it will also further
raise government debt from its historical peaks. And as the cost of living soars in
the wake of the sharp increases in the prices of food and energy, pressures to
provide additional support will mount. It is essential that this support be targeted
and temporary so as not to endanger fiscal sustainability further. So far, however,
governments have relied more on untargeted measures, which are more costly and
harder to reverse.
For monetary policy, the self-reinforcing nature of transitions from low- to
high-inflation regimes heightens the calibration difficulties (Chapter II). In general,
the self-equilibrating properties of inflation in a well established and credible lowinflation regime allow the central bank to accept moderate, possibly persistent
deviations, from narrowly defined targets. Indeed, this is desirable, since there is
evidence that, in such a regime, monetary policy loses traction owing to the large
role played by sector-specific (idiosyncratic) price changes. The more vigorous
actions required would increase any associated costs, such as those of interest rates
that remain exceptionally low for long.
But, crucially, once the regime is tested
hard, as it is now, the transition can gather speed. This puts a premium on a timely
and decisive response – all the more so given the well known lags with which
monetary policy affects expenditures and then inflation.
In such a context, two sources of uncertainty complicate the calibration.
The first concerns the evolution of inflation. The key problem is that leading
indicators have not proved fully fit for purpose (Chapter II). The broadening of price
pressures or the pickup in underlying measures of inflation can help, but they
provide relatively little information beyond short horizons. Measures of inflation
expectations can also be useful, but they have their own drawbacks. Those derived
from financial asset prices need not reflect the expectations of the economic agents
that matter most – workers and firms. And those derived from household and firm
surveys tend to be very backward-looking. In addition, more formal models, which
are necessary to chart the inflation path at longer horizons, are least reliable
precisely when needed most – during transitions. So far, these sets of indicators are
sending mixed signals. Broadening price increases and higher expectations provide
reasons to worry, at least for the near term; models tend to paint a more benign
picture, but arguably an overly rosy one.
By far the most reliable indicator is evidence of wages chasing prices – secondround effects. But by the time these are clearly visible, inflation may already be
becoming entrenched. Hence the need to focus on softer information, such as signs
of changes in inflation psychology and attitudes to price increases.
The second source of uncertainty concerns the strength of policy transmission.
As discussed, private debt levels at historical peaks and elevated valuations could
make expenditures especially sensitive. And after a long spell of unusually low
interest rates and ample liquidity, financial markets could overreact. While, so far,
financial conditions have tightened, sharper adjustments could be in store. In fact,
inflation-adjusted (real) interest rates have been falling as inflation has picked up.
BIS Annual Economic Report 2022 xv
Hence a policy dilemma opens up. Uncertainty about the evolution of inflation,
about financial market reactions and about expenditure decisions may counsel
caution. But the risk of inflation becoming entrenched calls for a more pre-emptive
and vigorous response. In navigating this dilemma, good communication may help,
but only up to a point. The overriding priority is to avoid falling behind the curve,
which would ultimately entail a more abrupt and vigorous adjustment. This would
amplify the economic and social costs of bringing inflation under control.
Against this backdrop, and cross-country differences aside, EMEs are especially
vulnerable. They are more at the mercy of global financial conditions, which are
likely to tighten further, including through dollar appreciation, and they have less
room for policy manoeuvre. So far, capital flows have been less disruptive than in
previous episodes, such as the taper tantrum. No doubt, more comprehensive
policy frameworks have helped, involving a judicious reliance on foreign exchange
intervention and macroprudential measures. And so has pre-emptive tightening
where incipient inflationary pressures were stronger. Also helpful is the fact that the
share of foreign investors in domestic markets has already shrunk. But the tougher
tests may still lie ahead.
