76th Annual Report, 2005/06

Global growth last year was again very rapid, in spite of higher prices for energy and other commodities. Moreover, core inflation generally stayed low even as headline inflation rose. Yet, as the year wore on, fears began to grow about prospective inflationary pressures. Concerns also began to mount about the growing imbalances in the global economy, not least the low saving and high investment levels in the United States and China, respectively, and record current account imbalances. Against this backdrop, monetary policy tightened in a number of industrial countries. Financial markets for the most part continued to have a very upbeat view of the future, especially for emerging market economies, although in mid-May 2006 uncertainty and volatility both increased. The US dollar, whose longer-term downward movement had been interrupted in 2005 in response to relatively high US policy rates, also began to weaken more sharply. More...

The world economy grew strongly in 2005 while inflation remained subdued. This outcome exceeded the optimistic forecasts of early 2005 despite headwinds from changes in the macroeconomic environment. First, inflationary pressures remained muted even as commodity prices rose further in the third consecutive year of buoyant world growth. Second, the US economy retained considerable strength despite the energy price hike and hurricane-related disruptions. Third, global financing conditions continued to be very supportive of growth, notwithstanding the progressive removal of monetary accommodation in the United States and, albeit less advanced, in the euro area. Finally, financial markets stayed calm despite the further massive and unexpected deterioration of the US current account balance during 2005. More...

The expansion in emerging market economies consolidated further in the period under review. In many countries, strong growth was accompanied by increasing export values and large current account surpluses. External debt burdens fell, foreign currency reserves rose further, fiscal positions improved, and balance sheets strengthened. Partly in response, consumer and investor confidence remained buoyant and growth was remarkably resilient in the face of higher oil prices even in oil-importing countries. More...

The overall thrust of monetary policy in the G3 economies remained accommodative, but took a distinctly firmer tone during the period under review. As signs of price pressures accumulated, the Federal Reserve continued to tighten policy with consecutive rate hikes. The ECB began to raise its policy rate, as headline inflation exceeded its target and momentum in economic activity strengthened; in addition, money, credit and asset price developments heightened concerns about longer-term price stability. As deflationary pressures faded, the Bank of Japan announced the end of its unconventional quantitative easing policy but initially left its policy rate unchanged at zero. The Bank also adopted a new two-perspective policy framework distinguishing between short- and long-run risks to price stability. Policies across smaller industrial economies with inflation targets were more diverse, with most central banks tightening. External developments once again played a major role in shaping the policy environment. High oil and other commodity prices fed concerns about worrisome second-round inflationary effects, while at the same time low-cost imported consumer goods raised prospects of underlying inflation running below target. More...

The broad appreciation of the US dollar, the stability of the euro and the overall downward trend of the yen were salient developments in foreign exchange markets over most of 2005. Starting in early December 2005, however, the upward trend of the US dollar reversed. As in previous years, three main factors underpinned exchange rate developments during the period under review: interest rate differentials, the current account deficit and rising net international liabilities of the United States, and continuing reserve accumulation in China limiting the dollar's depreciation against the renminbi. In contrast to earlier years, reserves grew more slowly in other emerging market countries in Asia. The change in China's exchange rate policy introduced in July 2005 received much attention, but by mid-May 2006 had only had a modest impact on foreign exchange markets. More...

Conditions in global financial markets remained calm and accommodative during most of the past year. This reflected the surprisingly strong performance of the world economy and still abundant liquidity. Up to the end of 2005, lower term premia - or a narrowing wedge between forward and expected short rates at long maturities - appeared to be responsible for flattening yield curves in the United States and the euro area. The prospect of additional monetary tightening due to higher growth and inflationary pressures resulted in higher long-tem yields starting in early 2006. However, its impact on the prices of other assets was only evident from mid-May, when volatility increased and equity and emerging debt markets fell sharply. More...

Financial firms in the advanced industrial countries registered strong performance during the year under review. Banks continued to harvest the benefits of past years' cost savings, a continuing benign credit environment and healthy volumes of retail business, which contributed to higher profits despite further compression in interest rate margins. The balance sheets of life insurance companies strengthened while the property and casualty sector managed a year of record claims without major problems. A boom in the activity of private equity funds was accompanied by intensive fund-raising and borrowing to finance leveraged buyouts. Hedge funds experienced a slowdown in inflows as performance slumped. More...

The best bet for next year is that strong, non-inflationary growth will continue. Yet there are considerable uncertainties and associated risks, not least concerning inflationary pressures on the one hand, and a possible unwinding of accumulated economic and financial imbalances on the other. These could lead to financial market turbulence or a long period of relatively slower global growth developments, or both. Fortunately, policies might be suggested that could reduce these risks materially. While the current phase of monetary tightening seems clearly justified, the issue of how higher rates and financial imbalances might interact needs careful consideration. This is particularly so against a backdrop of globalisation and shifts in relative prices which have, in any event, made it more difficult to gauge how much tightening is actually required. The burden placed on monetary policy, and the associated risks, could be reduced by concurrent fiscal tightening, particularly in countries like the United States with large current account deficits. Such support would also help reduce the risk of disorderly exchange rate movements. Structural reforms to aid internal adjustments between the tradable and non-tradable sectors in various countries would serve the same purpose. More...

This chapter summarises the BIS's contribution to international cooperation directed towards greater monetary and financial stability. It describes the institutional framework in which this cooperation is pursued, and highlights activities that marked the past year.

In June 2005 corporate governance was strengthened through a revision of the BIS Statutes approved at an Extraordinary General Meeting of the Bank's shareholders. Based on recommendations of a group of eminent legal experts, the revision abolished the position of President of the Bank, and recognised terms of reference for the Executive Committee as an advisory committee to the General Manager. Charters for the Board of Directors and several operational committees were drawn up.

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