77th Annual Report, 2006/07

The favourable global economic performance seen in recent years extended into the period under review. Global growth was strong and there were even welcome signs of better balanced demand. The US economy slowed somewhat, largely due to a weaker housing sector, while domestic demand in Europe, Japan and a number of emerging market economies picked up. Although output in many countries seemed to be close to potential, and commodity prices rose still further, overall inflation pressures remained muted. In this environment, there was a moderate tightening of monetary policies in many countries, although overall monetary and financial conditions remained highly accommodative. In part this was due to real policy rates remaining rather low, with associated effects on long-term interest rates. But it was also due to an increased willingness of lenders to advance credit to high-risk borrowers with less onerous conditionality than in the past. While the credit cycle has peaked in the subprime mortgage market in the United States, the expansion has continued in most other areas. As a result, global asset prices either continued to rise or were maintained at unusually high levels. Moreover, financing for the US current account deficit, as well as private capital outflows from the United States, continued to be available at terms that seemed to factor in expectations of only a very moderate further depreciation of the dollar. More...

The strength of the global economy surprised again in 2006. US consumption was unexpectedly resilient given the substantially weaker housing market, while there was a broad-based upswing in other advanced industrial countries alongside continued rapid growth in emerging market economies. Inflation remained subdued, with headline inflation receding in the second half of the year. However, underlying inflation pressures persisted, reflecting high, or rising, rates of resource utilisation in major economies. More...

Emerging market economies (EMEs) continued to record strong growth, moderate inflation and current account surpluses in 2006 and into the first quarter of 2007. Yet inflation pressures raised concerns in some countries, in part because of robust demand and in part due to uncertainties about commodity prices. Despite moderate monetary tightening, credit growth has remained strong in a number of EMEs. At the same time, fiscal consolidation and improved debt management have enhanced the resilience of EMEs. More...

The stance of monetary policy in the advanced industrial countries became less accommodative during the period under review, although the overall stance remained supportive. The Federal Reserve further raised its policy interest rate early in the period and then kept it on hold, despite lingering concerns about upside inflation risks. The ECB significantly reduced the degree of policy accommodation during the period as economic activity picked up, economic slack diminished and money and credit grew rapidly. Using its newly adopted two-perspective policy framework to explain its actions, the Bank of Japan ended its zero interest rate policy with two modest moves during the period, arguing that the ongoing recovery had gained sufficient traction, that underlying inflation fundamentals had strengthened and that maintaining a near-zero interest rate environment had raised medium-term risks of unsustainable investment trends. In smaller advanced industrial economies with inflation targets, there was a general tightening of monetary policy in the face of a diverse set of domestic and external forces, including uncertainties about the global outlook, dwindling slack, high commodity prices, robust money and credit growth, and strong capital inflows. More...

The main trends in foreign exchange markets over 2006 and the first four months of 2007 were the gradual depreciation of the US dollar, the more marked depreciation of the yen, and the appreciation of the euro in trade-weighted terms. Foreign exchange markets were characterised by high levels of trading activity and historically low volatility, although there were two episodes of higher volatility: in May-June 2006 and in late February-March 2007. More...

Prices of risky assets continued to rise throughout most of 2006 and early 2007. Two sell-offs during the period proved to be short-lived corrections rather than prolonged downturns. A number of equity markets reached historical highs, while various credit spreads touched new lows, despite a weaker economic outlook in the United States and indications that global growth might have peaked. In this environment, government bond yields in the advanced industrial countries levelled off around mid-2006 and then began to edge downwards. The United States, in particular, saw long-term bond yields falling during the second half of the year, reflecting investor concerns about US growth prospects and expectations that monetary policy would be easing. The economic outlook in Japan remained more positive, lending some support to bond yields, while the economic outlook for the euro area brightened progressively and eventually brought about rising euro bond yields. More...

The strong overall performance of financial firms in advanced industrial countries continued during the year under review. Banks benefited from another year of a generally benign credit environment and strong retail business. Once again, investment banks registered record profits driven by growth in capital markets activities and a boom in private equity. Investor inflows into hedge funds were moderate by past years' standards, in response to the declining rates of return registered by the funds. Hedge funds are, however, increasingly integrated in the international financial system as a result of requirements placed on them by a broadening range of investors, and of intensified pressure for enhanced disclosure or compliance with more detailed regulatory requirements. The balance sheets of life insurance companies strengthened, while the property and casualty sector continued to recover from a costly 2005 without major problems. More...

The consensus economic forecast expects the recent excellent global performance to continue. Yet at least four sets of concerns can be raised, even if our capacity to calculate both their likelihood and possible interdependence remains limited. First, a rise in global inflation pressures cannot be ruled out. Second, the current slowdown in the United States might prove more significant than expected and the global implications greater. Third, global current account imbalances, together with large and volatile capital flows, indicate an exposure to disruptive exchange rate changes with potential implications for financial markets as well as asset prices. And finally, with most asset markets already "priced to perfection", any unwelcome shock might have unexpected consequences. More...

The BIS focuses on promoting cooperation among central banks and other financial authorities, and on providing financial services to central bank customers. To further these ends, during the year the BIS acted to:

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