Markets should not fall into the trap of thinking that inflation is decisively on its way down, the Bank of International Settlements warned.
In its quarterly review, the Swiss-based organisation, which is known as the ‘central bank for central banks’, cautioned that stubborn inflation could cause difficulties in financial markets if it forces interest rates higher.
“The risk that inflation might turn out to be more stubborn than expected is something that we should not rule out,” Claudio Borio, chief economist at the Bank of International Settlements, said.
“Business models, trading strategies, that were predicated on that assumption (of rates coming down quickly) are particularly vulnerable to current conditions,” he added.
Markets are increasingly convinced that central banks have reached the end of their monetary tightening cycle, with traders expecting rate cuts in the second half of next year.
However, thanks to rising energy prices, the headline rate of inflation in the US ticked up in August. In the UK, inflation is expected to rise slightly when the latest figures come out on Wednesday.
These pressures could force banks to leave rates higher for longer or even raise rates again.
“Inflation could once again surprise on the upside,” Borio said. “Central banks are aware of the possible risks. It is about whether financial markets are properly taking into account these risks.”
Borio highlighted that higher interest rates could have knock-on impacts in terms of falling property prices and a rise in bankruptcies as banks restrict access to credit.
“Credit growth has been slowing in general and that asset prices, particularly I would say property prices, have started falling,” Borio said.
“The question is going to be how resilient the overall financial system is going to be in order to absorb those losses. And particularly how large and persistent those losses are going to be,” he added.