Banks' rate policies 'risk disastrous crash'

Central banks must carry out a wholesale revolution in the way they set interest rates to help avert a disastrous crash in the financial markets, the Bank of International Settlements warned today.

The BIS, known as the central banks' banker, said setting monetary policy to keep inflation low in the short term risked fuelling financial imbalances that could unwind suddenly, leading to a global economic slump. It urged policymakers to give greater weight to asset prices, lengthen their forecast horizon and use other regulatory-based tools to prevent asset price bubbles.

The comments are expected to ignite a vigorous debate on the issue especially among bodies such as the Bank of England that have rejected asset price targeting. In its annual report the BIS said: "The current conventional approach to the pursuit of price stability might need refinement. The Keynesian analytical framework, which remains the workhorse in the stable of most central bankers, needs modification."

It said banks needed a "much richer" set of indicators, particularly indicators of financial imbalances. This included external imbalances such as trade deficits and internal ones such as house price bubbles. "Over long periods of time, such imbalances can pose an even greater threat to price stability than shorter-tern and more conventional inflationary "pressures" such as output gaps," it said.