Bank for International Settlements, Basel, Switzerland.

The global economy may be close to a "tipping point" that could see it enter a slowdown so severe that it transforms the current period of rising inflation into a period of falling prices, the Bank for International Settlements (BIS) said on Monday.

In its 78th Annual Report released today, the central bank for central banks said the impact of rising food and energy prices on consumers' incomes, combined with heavy household debts and a pullback in bank lending, may lead to a slowdown in global growth that "could prove to be much greater and longer-lasting than would be required to keep inflation under control."

"Over time, this could potentially even lead to deflation," it said.

The BIS said that while a severe slowdown is not inevitable, it believes that the risks of a sharp downturn are very real, and centered on the financial system. It warned that the process of cutting back on borrowing after many years of accumulating debt could lead to "much slower growth than is generally expected."

The bank says that the reduced availability of credit could force some financial institutions to sell assets at a time when buyers are hard to find - an outcome that could lead to another round of price declines and losses at banks. "The impact of such fire sales on prices, and on the capital of financial institutions, could be substantial," it said.

The BIS said that after a number of years of strong global growth, low inflation and stable financial markets, the situation deteriorated rapidly in the period under review. Most notable was the onset of turmoil in the US market for subprime mortgages, which rapidly affected many other financial markets and eventually called into question the adequacy of capital at a number of large US and European banks. At the same time, US growth slowed markedly, reflecting setbacks in the housing market, while global inflation rose significantly under the particular influence of higher commodity prices.

This sudden change in financial conditions was blamed by some on shortcomings in the extension of the long-standing originate-to-distribute model to new mortgage products in recent years. Others, however, noted that the sudden deterioration in both financial and macroeconomic conditions looked more like a typical "bust" after a credit "boom". The bank says several factors seem to support this second hypothesis: the previous rapid growth of global monetary and credit aggregates; an extended period of low real interest rates; the unusually high price of many assets (both financial and real); and the way in which spending patterns in different countries (the United States and China in particular) reflected their different stages of financial development (encouraging consumption and investment respectively).

The BIS says a disorderly decline in the dollar remains a possibility as losses on US assets pile up and the current-account deficit triggers ``a sudden rush for the exits."

A plunge in the currency may happen even after its ``remarkably orderly'' 14 percent slide against the euro in the past year, the Basel, Switzerland-based BIS said in an annual report today.

``Foreign investors in US dollar assets have seen big losses measured in dollars, and still bigger ones measured in their own currency,'' the BIS said. ``While unlikely, indeed highly improbable for public-sector investors, a sudden rush for the exits cannot be ruled out completely.''

The fundamental cause of today’s problems in the global economy is excessive and imprudent credit growth over a long period, the BIS says. This always threatened two unwelcome outcomes: a rise in inflation and an accumulation of debt-related imbalances which would at some point prove to be unsustainable. In the event, both unwelcome phenomena are being experienced at the same time. Leaning against current inflationary pressures should imply a significantly less accommodating bias to global policy overall, even though this could create some short-run difficulties in some countries.

The BIS says it notes that the experience of the recent financial turmoil shows the need for a new macrofinancial stability framework to resist actively the inherent procyclicality of the financial system. This would require a primary focus on systemic issues and a much more countercyclical use of policy instruments (reducing the impact of a boom on the upswing of the business cycle). It also demands closer cooperation between the central banking and regulatory communities in trying to identify the build-up of systemic risks, deciding what to do to mitigate them, and agreeing in advance on steps that might be taken to manage periods of stress.  

Speaking today, BIS General Manager Malcolm Knight noted that “central banks face a difficult dilemma because inflation pressures have come to the surface just when downside risks to growth have increased”. Moreover, important aspects of central bank functions have come under consideration, including how they provide liquidity to banks and their role in financial system oversight. “The BIS looks forward to working closely with both central banks and regulators in developing better analytical frameworks for addressing these important questions,” Knight added.

The 78th Annual Report was presented at the Bank’s Annual General Meeting held today in Basel, Switzerland, and chaired by Jean-Pierre Roth, Chairman of the BIS Board of Directors. Representatives from more than 130 central banks and international institutions attended.

Annual Report