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LONDON (Reuters) - Major central banks should press ahead with interest rate increases, the Bank for International Settlements said on Sunday, while recognising that some turbulence in financial markets will have to be negotiated along the way.
The BIS, an umbrella body for leading central banks, said in one of its most upbeat annual reports for years that global growth could soon be back at long-term average levels after a sharp improvement in sentiment over the past year.
Though pockets of risk remain because of high debt levels, low productivity growth and dwindling policy firepower, the BIS said policymakers should take advantage of the improving economic outlook and its surprisingly negligible effect on inflation to accelerate the "great unwinding" of quantitative easing programmes and record low interest rates.
New technologies and working practices are likely to be playing a roll in suppressing inflation, it said, though normal impulses should kick in if unemployment continues to drop.
"Since we are now emerging from a very long period of very accommodative monetary policy, whatever we do, we will have to do it in a very careful way," BIS's head of research, Hyun Song Shin, told Reuters.
"If we leave it too late, it is going to be much more difficult to accomplish that unwinding. Even if there are some short-term bumps in the road it would be much more advisable to stay the course and begin that process of normalisation."
Shin added that it will be "very difficult, if not impossible" to remove all those bumps.
Good communication from central bankers will be important, but even more crucial is the need for banks to be strong enough to cope with any turbulence.
The BIS identified four main risks to the global outlook in the medium-term.
A sudden flare-up of inflation which forces up interest rates and hurts growth, financial stress linked to the contraction phase of financial cycles, a rise in protectionism and weaker consumption not offset by stronger investment.
The first seems unlikely for now at least, with Shin saying that the BIS, like many, had been surprised that inflation and wage growth has remained so subdued as growth in major economies has picked up.
The question for central bankers, therefore, is whether new technologies and working practices had fundamentally changed the inputs in their economic models and whether it is right to keep such a heavy focus on keeping inflation at certain levels -- near 2 percent for likes of the European Central Bank and U.S. Federal Reserve.
"Inflation is certainly not the only variable that matters ... and we should keep one eye at least on financial developments," Shin said.
A broadening away from inflation-targeting to financial market conditions would require a mindset change in large parts of the world and could speed up interest rate cycles.
When the U.S. Federal Reserve last embarked on rate increases more than a decade ago, it took two years to raise them from 1 percent to above 5 percent, with hikes at 17 consecutive meetings. In the current cycle, it has taken 18 months for a 1 percentage point increase.
The BIS report added that the lack of clarity over inflation also makes it far harder to judge how far rates could go up before they start coming down again.
"In practice, therefore, central banks have little alternative but to move without a firm end-point in mind," it said.
The report also touched on another current global theme -- protectionism, potentially one of the most damaging of the four main risks it identified.
One piece of research based on the U.S. transport industry estimated that if 10 percent tariffs were put on imports from Mexico or China, U.S. labour costs would have to drop by about 6 percent to compensate for the higher costs of "imported inputs".
For some of the largest emerging markets there were also concerns about dollar debt and protracted credit expansion, often alongside rising property prices, storing up risks. Low interest rates, though, have generally kept debt-service ratios below critical thresholds.
"The policy challenge is to take advantage of the current tailwinds to put the expansion on a sounder footing," said Claudio Borio, head of the BIS monetary and economic department.
"First and foremost, that requires building resilience, domestically and globally."
The BIS’s financial results, which were also published on Sunday, showed the Swiss-based bank had made a net profit $1.124 billion over the year to March 31 and had a balance sheet worth $329 billion.
Editing by David Goodman