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Central banks must address “frothy” markets, says global banking body

A global mega-bank has warned central banks this evening that their tightening of monetary policy may not be having the desired effect of cooling “frothy” financial markets.

In its quarterly review, the Bank for International Settlements (BIS) said that financial conditions – which include factors such as corporate bond spreads and equity market levels – were “paradoxically” easing while some major central banks were winding back stimulus.

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The global banking umbrella body pointed to the fact that, while the US Federal Reserve has made moves to remove monetary accommodation, yields of certain US Treasury notes have refused to rise and asset prices have remained high.

“Can a tightening be considered effective if financial conditions unambiguously ease? And, if the answer is ‘no’, what should central banks do?” said Claudio Borio, head of the BIS’s monetary and economic department.

“In an era in which gradualism and predictability are becoming the norm, these questions are likely to grow more pressing.”

Borio noted that headline equity market indices had approached or surpassed previous peaks, corporate spreads narrowed, and equity and bond yield volatility touched all-time lows seen only briefly in mid-2014 and before the financial crisis.

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“There would be nothing really surprising in this picture were it not for one thing: all this ebullience has taken hold even as the Federal Reserve has proceeded with its tightening,” Borio said.

The BIS report also raised alarm bells over the vulnerabilities presented by record high debt levels.

“Higher borrowing tends to boost economic activity in the short run, but there is evidence that it acts as a drag on growth at horizons of three years or more,” said the BIS’s economic adviser and head of research Hyun Song Shin.

“Household debt also has direct (through loan exposures) and indirect (through the impact of debt on GDP) effects on financial stability.”

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