Stephen Cecchetti, head of the International Settlement’s monetary and economic department, warns that interest rates may rise faster than expected and could send shocks through the market. “We’re concerned that investors are not prepared for what might happen,” he told Institutional Investor. “Quick interest rate increases obviously have an impact on the net worth of the balance sheet of somebody who’s leveraged.” Are markets prepared for a European default or debt restructuring? “At this point, I’m confident that the authorities here, as well as the financial institutions and the markets, are going to find a solution to the problem, and they’ll find it before there’s a Lehman-style collapse. Should policymakers actively seek to reduce the size of the financial sector and hence the potential danger? He notes that policymakers need to anticipate better than they have in the past. “When [interest rates] do start to rise, policymakers need to be prepared to increase them more rapidly than they have in the past.”
What concerns you about global monetary policy?
Over the last year headline inflation has gone up by a full percentage point and is now over 3.5 percent globally. Real interest rates have gone down and are now at –1.3 percent. So monetary policy has been easing, inflation has been rising, and slack has been disappearing. Obviously, that’s not true everywhere.
There are big capital flows, especially into emerging-markets countries. And they are creating problems, including credit booms, asset price booms and the like. Large, sudden credit growth is something that most economies can’t handle.
You warn that interest rates may have to rise sooner and faster than expected, even in advanced counries. Why?
Very low interest rates do have side effects: encouraging risk-taking behavior that may not be prudent in the long run, allowing people to delay adjustment of their balance sheets when they should be shedding debt.
We accept that in some parts of the world, interest rates do need to stay low. But when they do start to rise, policymakers need to be prepared to increase them more rapidly than they have in the past. We’re concerned that investors are not prepared for what might happen.
Why are you sure the new capital surcharge for “systemically important financial institutions” will boost stability but not hurt the economy?
Our original report showed only a very modest impact of increased capital charges spread over a number of years. The global SIFI capital surcharge should result in something that’s less onerous than the overall capital requirement. I would think most of the benefits come from reducing the chances that a systemically important financial institution runs into difficulties. We still don’t see much in the way of reduced lending or increased lending rates arising from these sort of things.
Should policy makers actively seek to reduce the size of the financial sector?
These capital charges, as well as a number of other regulatory requirements being imposed on financial systems worldwide, are effectively going to discourage financial activity, albeit modestly. We thought there was too much financial activity; we thought there was too much lending. The whole idea is to dial this stuff back.
There’s an interesting box in the report that shows there’s at least some evidence that the bigger and deeper your financial system is, beyond a certain point it reduces productivity in the rest of your economy. That’s not a big surprise, because if you’re overinvesting in finance, you’re attracting a lot of smart people and resources into finance that aren’t going into the rest of the economy.
Are markets prepared for a European default or debt restructuring?
At this point, I’m confident that the authorities here, as well as the financial institutions and the markets, are going to find a solution to the problem, and they’ll find it before there’s a Lehman-style collapse.
