By Paul Hannon 

Central bankers in the U.S. and Europe shouldn't be deterred from raising interest rates and winding back stimulus policies by the increased financial market volatility that will accompany their efforts, the Bank for International Settlements said Sunday.

In its annual report, the club for central banks welcomed a series of rate increases by the Federal Reserve, as well as the European Central Bank's intention to halt purchases of government bonds in December.

It urged policy makers to continue on the path of "normalization" even if that triggers sharper prices moves in financial assets, including those based in emerging markets. Indeed, the BIS said such volatility would be welcome if it made investors more cautious.

"Policy makers will need to maintain a steady hand, avoiding the risk of overreacting to transitory bouts of volatility," the BIS said. "Higher volatility per se is not a problem as long as it remains contained; it is actually healthy whenever it helps inhibit unbridled risk-taking."

The BIS also urged governments to cut back on their borrowings and said increased sales of Treasury bonds by the U.S. government could slow the global economic expansion.

The prospect of further rate rises by the Fed in 2018 has weakened some emerging markets currencies as investors shift their money into U.S. assets. However, the BIS said the Fed should not be deterred by those moves and that governments in emerging markets should do more to cushion themselves against the impact of capital outflows.

"This calls for other countries, in particular emerging markets countries, to strengthen their macro frameworks, and if possible to implement macroprudential policies to smooth the impact of this normalization," said Agustín Carstens, the BIS's general manager and formerly the governor of the Bank of Mexico.

Mr. Carstens said the long period of stimulative policies had created a number of "vulnerabilities," including "elevated" prices for shares and homes that have been fueled in part by increased borrowing.

"In previous episodes, such vulnerabilities have heralded a range of problems, including recessions," he said, according to the text of a speech to central bankers gathered in Basel, Switzerland for their annual meeting.

While welcoming the Fed's moves, the BIS highlighted U.S. government actions that could threaten the global economic recovery. In particular, it cited the dangers of a widening trade conflict and increased borrowing to fund tax cuts and increased spending.

"One possible trigger of an economic slowdown or downturn could be an escalation of protectionist measures," it said. "A second possible trigger could be a sudden decompression of historically low bond yields or snapback in core sovereign market yields, notably in the United States. The prospective heavy issuance of government debt...could add to this risk."

The BIS said that governments shouldn't be providing additional stimulus to economies that are already growing and should instead be cutting back on their debts.

"With due regard for country-specific circumstances, fiscal consolidation is a priority," it said.

Write to Paul Hannon at paul.hannon@wsj.com

(END) Dow Jones Newswires

June 24, 2018 06:44 ET (10:44 GMT)