BIS Warns Countries About Risks of Debt

The Bank for International Settlements delivered a stern message to central banks and governments that keeping interest rates low for too long, or failing to act quickly to cut budget deficits, could sow the seeds for the next crisis.

“The time has come to ask when and how these powerful measures can be phased out,” the BIS said in its annual report, referring to large fiscal and monetary stimulus measures initiated to lift economies out of recession.

The warning amounts to a direct challenge to the European Central Bank and U.S. Federal Reserve, the world’s dominant central banks, both of which have held their main lending rates at record lows for more that a year. Neither central bank is expected to begin raising rates until well into 2011 due to continued pressures in the financial system.

The BIS applauded central banks for cutting rates in response to the financial crisis, but cautioned that waiting too long to return to normal monetary policy could impose further damage on the global economy.

“Keeping interest rates very low comes at a cost—a cost that is growing with time,” the 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 the recommendations of the BIS. Yet the Basel-based organization’s stature as the “central bank for central banks”—a reference to the role it plays handling transactions for central banks—gives it an important voice on matters related to monetary policy.

The annual report was issued to central bankers from around the world, including Fed Chairman Ben Bernanke and ECB President Jean-Claude Trichet, who gathered for the BIS’s two-day annual meeting that ended Monday.

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,” the BIS said.

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

The Fed isn’t following that advice. Last week, Fed officials reiterated their commitment to keep rates “exceptionally low … for an extended period.”