BIS’s Borio urges return to fiscal-monetary separation

Central banks and governments should try to engineer an exit from the co-ordinated policies launched to tackle Covid-19, Claudio Borio said today (September 20).

Failing to move back towards separation of fiscal and monetary policies could trigger an “instability trap”, the Bank for International Settlements official said.

Borio, who heads the BIS’s monetary and economic department, told a conference at the Bank of Latvia: “The ultimate, most damaging, hazard would be a kind of ‘instability trap. In this scenario, rather than taking advantage of low rates to adjust, governments take the opportunity to raise debt further – a risk underlined by the belief that borrowing costs will remain structurally low.”

If the economy adapts to lower rates, it may become harder to raise them in the future, Borio argued, which could reduce both fiscal and monetary “headroom”.

A related issue is that quantitative easing makes the government’s finances more sensitive to interest rate risk, he said. By swapping long-dated government bonds for reserves with an overnight maturity, the government’s debt maturity profile may become illusory.

“Higher interest on reserves cut central bank profits (or raise losses) and hence depress remittances to the government,” Borio said. “Government debt may appear long-term, but in fact it is not. Given the size of central bank purchases of long-term government debt, in the largest advanced economy jurisdictions, as much as some 30–50% of it is already de facto overnight.”

His remarks came the same day as the BIS published its latest quarterly review. The BIS highlights how markets have remained buoyant despite growing “downside worries”. Government bond yields declined over the previous quarter, despite investors expecting a tightening of monetary policy.

Borio argued governments and central banks needed to return to a “corridor of stability”, where they would retain enough room to react to major shocks. This will require both to normalise policy over the medium term, implying higher interest rates and lower sovereign debt.

The added challenge is that the policies interact. Tighter fiscal and monetary policies are both contractionary. Higher rates make it harder for the government to service its debts, and fiscal consolidation makes it harder for the central bank to raise interest rates without dealing undue harm to the economy.

Failing to reaffirm the boundaries would heighten the risk of the ‘instability trap’

Claudio Borio, BIS

Borio said conditions were nevertheless “favourable” given the current differential between interest rates and growth in many countries, which helps to shrink the government debt. “This suggests that the window of opportunity should not be missed.”

He also urged policy-makers to “reaffirm clear boundaries” between fiscal and monetary policies. “Blurring the dividing lines was necessary during the Covid crisis,” he said. “But circumstances were exceptional. Failing to reaffirm the boundaries would heighten the risk of the ‘instability trap’.”

Lastly, he called for structural reforms to raise long-term growth, which would make it easier to adjust both the debt and monetary policy. “This requires reinvigorating structural reforms, which have been flagging for at least a decade now,” the BIS official said.