BIS WARNS CENTRAL BANKS AGAINST KEEPING RATES LOW FOR TOO LONG / THE WALL STREET JOURNAL ( RECOMMENDED READING )

June 28, 2010, 6:00 AM ET.

BIS Warns Central Banks Against Keeping Rates Low for Too Long.

The Bank for International Settlements issued a stern warning to central banks — keeping rates low for too long, and other actions like buying government bonds, creates risks to financial stability and opens central banks up to political pressure.

The warning, contained in BIS’s annual report, comes as Europe’s debt crisis has pushed rate-increase forecasts for major central banks including the Federal Reserve, Bank of England and European Central Bank off until well into 2011.

BIS concedes that slashing rates to record lows “was necessary to prevent the complete collapse of the financial system,” and isn’t recommending imminent hikes. Rather, the Basel, Switzerland-based organization, known as the central bank for central banks, worries that the latest crisis in Europe may delay for too long a “necessary” return to normal monetary policy.

“Keeping interest rates very low comes at a cost — a cost that is growing with time,” BIS said. “Experience teaches us that prolonged periods of unusually low rates cloud assessments of financial risks, induce a search for yield and delay balance sheet adjustments,” BIS said.

Central banks aren’t bound by BIS recommendations. But they’re significant nonetheless. The annual report was issued to central bankers from around the world gathered for BIS’s two-day annual meeting.

BIS took a veiled swipe at the Fed’s commitment, reiterated at last week’s FOMC meeting, to keep rates “exceptionally low… for an extended period.” Fed watchers equate that will holding rates near zero — where they’ve already been since the end of 2008 — for many more months.

By keeping short-term rates low, central banks give financial institutions the opportunity to generate income by borrowing at low rates and buying higher-yielding long-term assets. That, in turn, “may diminish the sense of urgency for reducing leverage and selling or writing down bad assets,” BIS said.

“Central banks’ commitment to keep policy rates low for extended periods, while useful in stabilizing market expectations, may contribute to such complacency,” BIS said.

BIS officials also worry about the effect soaring government debt levels will have on monetary policy and, ultimately, inflation. If investors are unwilling to buy a country’s sovereign debt, then the central bank may have to step in and purchase government bonds, which is what the ECB has done for Greece, Portugal and others to the tune of over 50 billion euros so far. The problem, BIS says, occurs when a central bank eventually has to stem inflationary pressures by pushing up short-term interest rates, thus raising borrowing costs for already cash-strapped governments.

“The rise in interest rates would be rapidly translated into higher interest payments and hence higher debt, thereby bringing forward the likely time for monetization,” BIS wrote.

BIS doesn’t see this type of inflationary scenario happening anytime soon. In fact, the opposite has occurred in traditional safe-havens like the U.S., where Treasury yields have fallen despite a double-digit deficit as a share of GDP. Many economists are worried about deflation, not inflation. But BIS warns “any increase in the probability attached to (high-inflation scenarios related to government debt) could quickly have adverse effects.”

Asset purchases “have exposed central banks to considerable credit risk,” BIS said, “which together with the changed balance sheet composition may expose them to political pressures.”

BIS isn’t just worried about central banks. Commercial bank profits “may prove unsustainable,” BIS said, noting that profits have been driven by fixed-income and currency trading — which can be volatile — and a steep yield curve, a flattening of which would raise funding costs. “It is not clear whether all crisis-related losses have been recognized,” BIS said.

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