March 10, 2014 / 12:32 AM / 5 years ago

Central bank guidance soothes markets but also carries risks: BIS

WASHINGTON (Reuters) - Central bank efforts to become more predictable on future interest rate moves have smoothed out short-term upsets in financial markets but could also lead to excessive risk-taking, research from the Bank for International Settlements said on Sunday.

The sun rises to the east of the U.S. Federal Reserve building in Washington, July 31, 2013. REUTERS/Jonathan Ernst

Central bank forward guidance, whether publishing rate forecasts or promising rates will remain at certain levels for a given time or until certain economic conditions are reached, has been in the spotlight recently as economies recover from the financial crisis and investors try to pick the beginning of the end of easy money policies.

Research published in the BIS quarterly review found guidance from the Bank of England, European Central Bank and Federal Reserve had a calming influence on markets and also helped shield the UK and euro zone economies from turbulence last year about when the Fed slowing asset purchases.

But BIS economists said there were risks from markets focusing too narrowly on certain aspects of forward guidance and from central banks themselves potentially becoming too worried about markets’ reaction, to the extent that it could delay a return to more normal policy settings.

This could “raise the risk of an unhealthy accumulation of financial imbalances,” the report said.

“Moreover, the mere perception of this possibility, over time, could encourage excessive risk-taking and thereby foster a build-up of financial vulnerabilities,” the paper said, adding that it was not clear whether forward guidance would become a permanent feature of central bank communication or prove to be only useful in times of crisis.

For the Fed, introducing a pledge that rates will remain close to zero until well past the time that the unemployment rate reaches 6.5 percent, as long as inflation does not threaten to rise above 2.5 percent, meant markets reacted less to the release of monthly non-farm payrolls figures - but this would change as the threshold came nearer.

“Interest rate futures are likely to become more sensitive to labor market developments as the threshold is approached,” the paper said.

The U.S. jobless rate ticked up to 6.7 percent in February, giving policymakers some breathing room to consider how to adjust guidance. But interest rate futures showed that traders ramped up bets after Friday’s data on the Fed raising rates a bit sooner than had been previously thought.

The BoE faced a similar dilemma: last year, it said it would only consider interest rate hikes when unemployment fell to 7 percent. But with that threshold approaching, the BoE last month broadened the focus of the guidance towards a wider assessment of spare capacity, or slack in the economy.

For its part, the ECB has vowed to keep interest rates “at present or lower levels for an extended period of time.”

A separate article in the report found non-U.S. banks had a disproportionate share of reserves at the Fed since they found it cheaper to raise wholesale funding than their domestic counterparts. At the end of 2013, they held almost $1 trillion of the $2.2 trillion reserves, 43 percent of the total, compared to their 13 percent share of total U.S. banking assets.

But the paper said this could change if reverse repurchase operations, a way to control short-term rates, were standardized as part of the Fed’s tool kit, especially if combined with a reduction in the bond portfolio.

“For some banks, especially U.S. branches of non-U.S. banks, it would reduce any profit to be made by taking in wholesale funds at 10 basis points (or less) and holding reserves at the Fed at 25 basis points. In effect, the new operations disintermediate the banks that have done this low-risk trade,” the paper said.

In reverse repos, the Fed temporarily drains cash from the financial system by borrowing funds overnight from banks, large money market mutual funds and others, and offering them Treasury securities as collateral.

Reporting by Krista Hughes; Editing by Eric Walsh

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