75th Annual Report, 2004/05

Looking back over the past two decades, several global economic trends can be identified. Lower and less volatile inflation, accompanied by higher and less volatile output growth, were welcome features. Less welcome were growing external and internal imbalances, the latter leading to more frequent periods of financial stress often associated with rapid increases in credit, asset prices and fixed investment. All these trends have their roots in three major structural changes: the spread of liberalisation throughout the global economy; the development of more complete financial markets; and the increased focus of central banks on low inflation. Looking back over the last fiscal year, strong growth and low inflation were maintained, but so too were external imbalances. Financial markets showed further evidence of overextension, reflecting the search for yield given very low policy rates, and house prices in many countries set new records. More...

The world economy grew strongly in 2004, supported by expansionary monetary policies and unusually accommodative financial conditions. Sharply rising commodity prices failed to spark generalised inflation, but helped to moderate the global expansion in the latter part of the year. After a synchronised upswing in the first half of 2004, growth differentials widened again as commodity importers experienced a slowdown - with the notable exception of the United States and China - while activity in commodity-exporting countries generally continued to grow apace. More...

During the year under review, growth in all the major emerging market regions was surprisingly strong, reflecting a better balance between external and domestic demand. Rapid growth put pressure on many critical raw materials, such as oil, but higher commodity prices did not lead to a marked resurgence of inflation. Interest rates in Asia and elsewhere remained low. More...

With the US economic expansion continuing strongly and risks shifting towards possible inflationary pressures, the Federal Reserve began reducing the degree of accommodation in a series of measured increases in the federal funds rate target. The ECB kept its policy rate unchanged as sub-par economic growth and the appreciation of the euro continued to hold back inflationary pressures. The Bank of Japan held its policy rate at zero as economic and financial headwinds proved sufficiently strong to rule out an end to deflation. Implementation of its quantitative easing policy became more complicated as changing liquidity demands emerged. In short, then, the stance of monetary policy in the G3 economies remained accommodative in the period under review. Policies across smaller industrial economies with inflation targets were more differentiated, with some central banks choosing very accommodative policy stances while others moved to more neutral settings. External developments, especially movements in the prices of oil and other commodities, dominated the last financial year. There are some striking parallels between current developments and movements in the late 1960s and early 1970s: a special section of the chapter therefore reviews the historical record and seeks to clarify the risks monetary policymakers might now face. More...

The continued broad depreciation of the US dollar and its subsequent partial reversal were the salient features of foreign exchange markets. In 2004 the dollar again depreciated against the euro, the yen and a number of other floating currencies. A new development last year was that the dollar also lost ground against several Asian emerging market currencies. Since January 2005, however, the currency's downward trend has partly reversed. Three main factors appeared to underpin exchange rate movements: market participants' focus on the widening US current account deficit and on rumours of changes in the currency composition of Asian central banks' portfolios; shifting expectations for relative output growth and interest rate changes; and official foreign exchange reserve accumulation in Asia. A special section considers whether the pattern of current account balances or the pattern of currency shares in global portfolios pose problems for the international monetary system. More...

Conditions in global financial markets eased during the financial year, despite a significant tightening of monetary policy in the United States; long-term rates in the major markets fell, equity prices rose and credit spreads narrowed. Investors in credit and equity markets were confident about corporate profits and the macroeconomic outlook, underpinned by significant improvements in fundamentals. In credit markets, structural changes that have facilitated hedging and promoted liquidity may also have contributed to the low level of spreads. The willingness of investors to accept greater risk was also a key source of support for credit and equity valuations. The juxtaposition of low yields with a seemingly robust economy and rising policy rates was something of a puzzle. Contained inflation expectations and diminished uncertainty about the course of monetary policy helped to keep yields down; more technical supply-demand factors may also have played a role. More...

Banks and insurance companies in industrialised countries registered stronger performance during the year under review. Lower costs, the improved credit environment and healthy revenues from retail business contributed to higher profits. Structural improvements meant that better performance was also evident in jurisdictions that had experienced strains in the past. The search for yield continued to compress spreads in credit markets and risk-taking by investment banks persisted, helped by liquid funding conditions. The hedge fund sector experienced large inflows, while returns have declined. More...

While the global economy performed very well in the fiscal year ending March 2005, worrisome signs began to emerge reminiscent of the inflationary pressures that built up in the late 1960s. Fortunately, closer analysis reveals enough differences, and lessons drawn from that earlier period, to conclude that history is not likely to repeat itself. Yet these differences give some hints about the likely nature of future problems. Internal and external imbalances, rooted in major structural changes in the global economy, could unwind with a potentially disruptive impact. What might seem evident policy solutions for each country considered alone often stand in mutual contradiction. This raises the issue of whether cooperative solutions might not have a role to play in current circumstances. Those who worry about the unwelcome interaction of otherwise desirable structural changes ask whether the policy framework might not also have to be modified in response. Suggestions can be made as to how both a domestic and an international macrofinancial stabilisation framework could be put into operation. Given the reality of vested sovereign interests, however, an international framework will be much harder to implement. More...

This chapter summarises the role of the BIS in international cooperation directed towards greater monetary and financial stability. It describes the institutional framework in which this cooperation is pursued, as well as the various related activities that marked the past year. In addition to its regular activities, the Bank will also be staging its first ever public exhibition, publishing a book on the history of central bank cooperation and hosting an academic conference as part of the festivities organised to celebrate its 75th anniversary in 2005.

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