IMF update

 

Dear MARIA, We just published a new blog—please find the full text below.  Central Banks Must Remain Vigilant Along the Last Mile of Disinflation (Credit: grandfailure / AdobeStock) By Tobias Adrian A sense of optimism has pervaded financial markets in recent months, amid investor confidence that the fight against inflation is entering its “last mile” and that central banks will ease monetary policy in the coming months. Stock markets around the world have risen substantially this year. Corporate and sovereign borrowing spreads have narrowed. And major emerging markets’ currencies and capital flows have remained resilient, while several frontier markets have regained access to international funding markets. And yet, there are likely to be bumps along this last mile, as we show in the latest Global Financial Stability Report. Geopolitical tensions could intensify and weigh on investor sentiments. Strains in commercial real estate have become more acute, which could increase pressure on some lenders. China’s financial markets continued to be weighed down by ongoing problems in the property sector. Beyond these more immediate concerns, debt vulnerabilities continue to grow, with both the public and private sectors in many countries borrowing heavily, even though interest rates are still high and economic growth will likely not accelerate, as projected by the World Economic Outlook. Taking a step back, there is recent evidence that disinflation may have stalled in some countries, and that underlying inflation may be persistent in some sectors. In some cases, core inflation has come in higher than analyst forecasts for consecutive months. Higher-than-expected readings could challenge the last-mile narrative and the related investor optimism, potentially leading to financial market repricing and higher volatility.  Sticky inflation After decelerating quickly worldwide, inflation has diverged more recently across countries. Data so far this year show that core inflation accelerated in the most recent three months versus the three months prior in a number of major advanced and emerging economies (Czech Republic, France, Germany, Italy, Philippines, South Africa, Sweden, United Kingdom, United States). Looking ahead, some investors appear to anticipate price pressures may not subside rapidly. Expectations for inflation in major economies over the next year or two—implied by the difference between nominal and inflation-linked government bond yields—have been climbing again. Importantly, they remain above central bank target levels of 2 percent, as in France, the United Kingdom and the United States, or 3 percent, as in Brazil and Mexico. Other measures of inflation expectations, like those from household surveys, appear more stable.  At the same time, an intensification of geopolitical tensions could further disrupt shipping and energy production and push up inflation once again. So far, financial markets have remained broadly sanguine about stalling disinflation and other headwinds and risks, with volatility in major asset classes currently at low levels despite elevated measures of economic policy uncertainty.  Repricing risks Traditionally, a divergence between asset price volatility and uncertainty has preceded volatility spikes, which could occur when investors are jolted by adverse shocks, prompting their re-valuing of assets to account for high uncertainty. One such adverse shock along the last mile could be upside inflation surprises. Despite the aforementioned uptick in projected future inflation in various countries, investors anticipate substantive policy rate cuts this year—reduction of about 75 basis points by the European Central Bank and the Central Bank of Brazil. Despite a string of upside inflation surprises in the United States, the Federal Reserve is still expected to cut rates by about 50 basis points. Investors appear to trust that data-dependent central banks will ease monetary policy when inflation decelerates further. But if inflation remains high, such lofty expectations could topple, which could lead to a correlated selloff of assets, from bonds to stocks to crypto assets. Under this scenario, financial conditions would broadly tighten. Most immediately, some investors would face losses on the assets they hold, especially leveraged investors whose negative returns would be magnified. Globally, borrowers would find it harder to service debt, given higher bond yields. Emerging market borrowers are often disproportionately affected in these situations. Many such issuers already face refinancing rates higher than interest rates on outstanding US dollar-denominated sovereign bonds. More vulnerable emerging markets—those with credit ratings of B and CCC or below—face the largest increase in rates. An inflation-driven tightening of global financial conditions would make refinancing even more difficult.  Commitment to disinflation The stalling of disinflation may surprise investors who are increasingly convinced that the battle against inflation has already been won and that low rates will prevail again. In economies still experiencing persistent and above-target inflation, central banks should not prematurely ease to avoid having to backpedal later. They should also push back against overly optimistic investor expectations for monetary policy easing, which has led to some exuberance in financial markets. Of course, where progress on inflation suggests it is moving sustainably toward target, central banks should gradually move to a less restrictive stance of policy.  Preserving financial stability along the last mile requires a multi-pronged approach. Financial regulatory authorities should take steps to ensure banks and other institutions can withstand defaults and other risks, using stress tests, early corrective actions, and other supervisory tools. Regulators should prioritize full and consistent implementation of internationally agreed prudential standards, notably finalizing the phase-in of Basel III. Further progress on recovery and resolution frameworks is also of first order importance, to limit the fallout from the demise of weaker institutions. Central banks should ensure banks have access to liquidity facilities when needed and be prepared to intervene early to address funding stress in the financial sector. —This blog is based on Chapter 1 of the April 2024 Global Financial Stability Report. —For more, listen to the podcast with Deputy Director Fabio Natalucci and Assistant Director Jason Wu of the IMF’s Monetary and Capital Markets Department, or watch the press briefing here. Global Economy Remains Resilient Despite Uneven Growth, Challenges Ahead (Credit: quietword / AdobeStock) By Pierre-Olivier Gourinchas Despite gloomy predictions, the global economy remains remarkably resilient, with steady growth and inflation slowing almost as quickly as it rose. The journey has been eventful, starting with supply-chain disruptions in the aftermath of the pandemic, an energy and food crisis triggered by Russia’s war on Ukraine, a considerable surge in inflation, followed by a globally synchronized monetary policy tightening. Global growth bottomed out at the end of 2022, at 2.3 percent, shortly after median headline inflation peaked at 9.4 percent. According to our latest World Economic Outlook projections, growth this year and next will hold steady at 3.2 percent, with median headline inflation declining from 2.8 percent at the end of 2024 to 2.4 percent at the end of 2025. Most indicators continue to point to a soft landing. We also project less economic scarring from the crises of the past four years, although estimates vary across countries. The US economy has already surged past its prepandemic trend. But we now estimate that there will be more scarring for low-income developing countries, many of which are still struggling to turn the page from the pandemic and cost-of-living crises. Resilient growth and rapid disinflation point toward favorable supply developments, including the fading of energy price shocks, and a striking rebound in labor supply supported by strong immigration in many advanced economies. Monetary policy actions have helped anchor inflation expectations even if its transmission may have been more muted, as fixed-rate mortgages became more prevalent. Despite these welcome developments, numerous challenges remain, and decisive actions are needed. Inflation risks remain Bringing inflation back to target should remain the priority. While inflation trends are encouraging, we are not there yet. Somewhat worryingly, progress toward inflation targets has somewhat stalled since the beginning of the year. This could be a temporary setback, but there are reasons to remain vigilant. Most of the good news on inflation came from the decline in energy prices and in goods inflation. The latter has been helped by easing supply-chain frictions, as well as by the decline in Chinese export prices. But oil prices have been rising recently in part due to geopolitical tensions and services inflation remains stubbornly high. Further trade restrictions on Chinese exports could also push up goods inflation. Economic divergences widen The resilient global economy also masks stark divergence across countries. The strong recent performance of the United States reflects robust productivity and employment growth, but also strong demand in an economy that remains overheated. This calls for a cautious and gradual approach to easing by the Federal Reserve. The fiscal stance, out of line with long-term fiscal sustainability, is of particular concern. It raises short-term risks to the disinflation process, as well as longer-term fiscal and financial stability risks for the global economy. Something will have to give. Growth in the euro area will rebound but from very low levels, as past shocks, and tight monetary policy weigh on activity. Continued high wage growth and persistent services inflation could delay the return of inflation to target. However, unlike in the United States, there is little evidence of overheating, and the European Central Bank will need to carefully calibrate the pivot toward monetary easing to avoid an inflation undershoot. While labor markets appear strong, that strength could prove illusory if European firms have been hoarding labor in anticipation of a pickup in activity that does not materialize.  China’s economy remains affected by the downturn in its property sector. Credit booms and busts never resolve themselves quickly, and this one is no exception. Domestic demand will remain lackluster unless strong measures address the root cause. With depressed domestic demand, external surpluses could well rise. The risk is that this will further exacerbate trade tensions in an already fraught geopolitical environment. Many other large emerging market economies are performing strongly, sometimes benefiting from a reconfiguration of global supply chains and rising trade tensions between China and the US. These countries’ footprint on the global economy is increasing. Policy path Going forward, policymakers should prioritize measures that help preserve or even enhance the resilience of the global economy. The first such priority is to rebuild fiscal buffers. Even as inflation recedes, real interest rates remain high and sovereign debt dynamics have become less favorable. Credible fiscal consolidations can help lower funding costs, improve fiscal headroom and financial stability. Unfortunately, fiscal plans so far are insufficient and could be derailed further given the record number of elections this year. Fiscal consolidations are never easy but it is best not to wait until markets dictate their conditions. The right approach is to start now, gradually, and credibly. Once inflation is under control, credible multiyear consolidations will help pave the way for further monetary policy easing. The successful 1993 US fiscal consolidation and monetary accommodation episode comes to mind as an example to emulate. The second priority is to reverse the decline in medium term growth prospects. Some of that decline comes from increased misallocation of capital and labor within sectors and countries. Facilitating faster and more efficient resource allocation will boost growth. For low-income countries, structural reforms to promote domestic and foreign direct investment, and to strengthen domestic resource mobilization, will help lower borrowing costs and reduce funding needs. These countries also must improve the human capital of their large young populations, especially as the rest of the world is aging rapidly. Artificial intelligence also gives hope for boosting productivity. It may do so, but the potential for serious disruptions in labor and financial markets is high. Harnessing the potential of AI for all will require that countries improve their digital infrastructure, invest in human capital, and coordinate on global rules of the road. Medium-term growth prospects are also harmed by rising geoeconomic fragmentation and the surge in trade restrictive and industrial policy measures. Trade linkages are already changing as a result, with potential losses in efficiency. The net effect could well be to make the global economy less, not more, resilient. But the broader damage is to global cooperation. It is still time to reverse course. Third, a great achievement of the past few years has been the strengthening of monetary, fiscal and financial policy frameworks especially for emerging market economies. This has helped make the global financial system more resilient and avoid a permanent resurgence of inflation. Going forward, it is essential to preserve these improvements. That includes protecting the hard-won independence of central banks. Lastly, the green transition requires major investments. Cutting emissions is compatible with growth and activity has become much less emission-intensive in recent decades. But emissions are still rising. Much more needs to be done and done quickly. Green investment has expanded at a healthy pace in advanced economies and China. The greatest effort must now be made by other emerging market and developing economies, which must massively increase their green investment growth and reduce their fossil fuel investment. This will require technology transfer by other advanced economies and China, as well as substantial private and public financing. On these questions, as well as on so many others, multilateral frameworks and cooperation remain essential for progress. —This blog is based on Chapter 1 of the April 2024 World Economic Outlook. Jeff Kearns Managing Editor IMF Blog jkearns@IMF.org   Thank you again for your interest in IMF Blog. Read more of our latest content here. Take good care!