Central bank body BIS urges cenbanks not to squander interest rate buffers

The Bank for International Settlements (BIS) has urged top central banks not to squander the interest rate buffers they have rebuilt over the last couple of years by now cutting them again too rapidly.

The recommendation from the central bankers’ central bank, as the BIS is known, prior to the US Federal Reserve’s first interest rate cut in four years.

BIS Monetary and Economic Department head Claudio Borio stressed that its message was to all central banks that they needed to maintain some “safety margins” to be able to handle both expected downturns and unexpected future crises.

“It would be a pity if this room for manoeuvre was squandered,” Borio told reporters as the BIS published its latest quarterly report on Monday.

“The expected is recessions that are bound to come. The unexpected are the types of COVID shocks that we saw. So that is one additional consideration to bear in mind when deciding the pace and how far to go”.

The Fed’s rate cut was its first in four years, but others, including the European Central Bank, the central banks of Britain, Canada, Switzerland, New Zealand, and many emerging market central banks, have already started the process.

Markets have been struggling to decipher where rates are likely settle this cycle though given the current uncertainty over the global economy. Borio said that neutral rate, or r* in economic textbook speak, was a “rather blurry concept”.

“You only find out where r* star is, when you get there somehow,” he said.

BIS on carry trade

The BIS’ report also unpicked August’s steep falls in supersized US tech and world stocks and the dramatic moves when the Bank of Japan’s move towards higher interest rates saw a sudden unwinding of hugely popular yen carry trades.

That trade, which involves borrowing yen at a low cost to invest in other currencies and assets offering higher yields, has underpinned markets for decades.

As well as the yen spike, August’s turmoil included the biggest single day drop for Japan’s TOPIX banks index in its 40 year history as well as a major jump in the main global market fear gauge, the Chicago Board Options Exchange’s Volatility Index (VIX).

Hyun Song Shin, the BIS’ head of research and top economic adviser, said the notional scale of outstanding FX swaps and forwards with the yen on one side – has soared by some 27 per cent since the end of 2021 to $14.2tn (JPY1.98tn).

However, there wasn’t enough information at the moment on how potentially destabilising an unwind of the carry trade could be.

“One thing that we will need to do is to have better data on the direction of the trade to get a sense of what the economic purpose of that transaction actually is,” Shin added. “This is something that we’re working on at the moment.”

Vulnerability

The Switzerland-based BIS also flagged financial stability concerns over the use of offshore reinsurance – insurance for insurers – provided by private equity firms in the life insurance market.

The report said this type of reinsurance is making the market “increasingly interconnected” and exposing life insurers to riskier assets. It estimates that private equity (PE0 firms’ investment in life insurance has grown nearly sevenfold since 2010, particularly in the US.

The Bank of England has threatened to curb UK life insurers’ use of PE-backed reinsurance, and global regulators are also worried about it.

Private equity players “could prove more vulnerable than peers in difficult market conditions”, the BIS warned.

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